You might have heard investors or financial experts discuss hedging. Hedging is a strategy used to minimize risk by investing in other assets or strategically managing cash. While it may seem complicated, the basic idea of hedging is quite straightforward.

Here’s a simple overview of what hedging is and how it operates.

What is a hedge?

A hedge is an investment designed to reduce financial risk. It works by holding an asset that behaves differently from your primary investment. If your main investment loses value, the hedge can help offset or minimize the overall loss.

Hedges can take various forms, including derivatives like options or simpler assets like cash. Some investors use short selling to protect against potential market declines and adjust their portfolios to benefit from such downturns.

A common, often unrecognized form of hedging is diversification. By spreading investments across different assets—such as stocks, bonds, or various sectors—you reduce the risk of a significant loss. This strategy assumes that not all investments will perform the same way at the same time. While some assets may rise, others might fall, balancing out the overall risk. If you could perfectly predict market movements, diversification wouldn’t be necessary.

How hedging works

One common hedging method involves using derivatives, which are financial instruments whose value depends on an underlying asset, such as stocks, commodities, or market indexes like the S&P 500. By employing a derivative related to the asset you’re hedging, you can directly manage your risk of loss. Here’s a practical example:

Suppose you’ve bought a stock at $100 per share, but you’re worried that an upcoming earnings report might disappoint and cause the stock to drop. To limit your potential loss, you could purchase a put option on the stock with a strike price you’re comfortable with. For instance, a put option with a $95 strike price would let you sell the stock at $95, even if the stock price falls below that.

Here’s how this would play out:

  • If the stock drops to $80 per share: You can exercise your option to sell at $95, thus capping your loss to $5 per share ($100 purchase price minus $95 strike price) plus the cost of the option.
  • If the stock rises to $110 per share: You benefit from the $10 increase in stock price, though the option expires worthless. Your net gain would be $10 per share minus the cost of the option.

Large companies frequently use derivatives to hedge against fluctuations in input costs. For example, airlines often hedge jet fuel prices to avoid the volatility of the spot market, while food producers might hedge prices for essential ingredients like corn or sugar.

Alternatively, simpler hedging strategies include maintaining a cash reserve to cushion against market downturns or diversifying investments across different asset classes or regions.

Benefits of hedging

  • Risk Mitigation: The primary advantage of hedging is its ability to manage risk and control your investment exposure. By using derivatives, you can safeguard yourself against unexpected market movements.
  • Limit Losses: Hedging enables you to cap your potential losses to an amount you’re comfortable with. While the cost of the hedge might limit your potential gains, it ensures that your losses won’t exceed a predetermined level in case of a price decline.
  • Price Certainty: Both companies and individuals, such as farmers, use derivatives to reduce the uncertainty of future commodity prices. Through futures and forward contracts, they can secure prices for essential goods well before their delivery, providing greater financial stability and predictability.

Risks of hedging

  • Limited Gains: While hedging helps protect against potential losses, it also limits your potential gains. If your investment appreciates significantly and the hedge proves unnecessary, you’ll forfeit the cost of the hedge. For instance, if a farmer locks in a price for corn in advance but the spot market prices rise, the farmer misses out on those higher profits.
  • Costs: Hedging incurs costs, either through the direct expense of a derivative contract or by accepting lower profits in exchange for protection. It’s important to fully understand the costs involved before committing to a hedge.
  • Incorrect Analysis: Sometimes, the hedge you chose may not work as intended. For example, if you invest in airline stocks and use energy company stocks as a hedge against rising fuel costs, a broader economic downturn might lower both oil prices and travel demand. This scenario could negatively impact both industries, making your hedge less effective than anticipated.

Should you consider hedging your investments?

For most long-term investors, hedging is generally unnecessary. If you’re investing with a long-term goal like retirement, short-term market fluctuations are less critical, and hedging might end up being more disruptive than beneficial to your portfolio. Historically, long-term investing rewards patience, with higher returns often compensating for short-term volatility.

On the other hand, if you have an active investment strategy or engage in frequent trading, hedging could be a useful tool for managing risk. However, it’s essential to understand the costs involved and how the hedge interacts with your overall investment strategy.

In Conclusion

Hedges can be effective for managing investment risk, but they often come with costs and can limit potential returns. For most long-term investors, hedging might not be necessary and could even detract from your long-term gains. A proven strategy is to invest in low-cost index funds, which have demonstrated strong performance over the long run, regardless of market fluctuations.