Hedging in investing is a strategy to reduce or eliminate specific financial risks, akin to insurance, but it comes with complexities, costs, and potential limitations on returns.
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the plain bagel to save 10 off your
first purchase of a website or domain
using code the plain bagel fluctuations
in the stock market can cause a lot of
stress for investors
well most advisors recommend ignoring
day-to-day fluctuations
it can be hard to look away when things
are bumpy it's easy to become obsessive
when things start to slide
in times like these many of us probably
wish that we could insure our
investments against downturns
in the same way we can insure our cars
against crashes
entering some sort of agreement where we
are compensated if something bad happens
to us
well the truth is that that sort of does
exist in the world of investing
but it goes by a different name hedging
when we hedge an investment we reduce or eliminate
eliminate
certain risks that could negatively
impact our holdings
including but not limited to stock
market crashes
as a whole it's a popular practice and
some funds
known as hedge funds even purport
offering investments with no exposure to
certain risks
which might make them seemingly
attractive to investors
but buyer beware these strategies come
at a cost
and while hedging is a risk reduction
strategy a poorly managed hedge
can actually put you in a worse position
than taking the risk on yourself
so let's learn about hedging and its
pros and cons on today's plain bagel
when you hear the word hedging you
probably imagine some kemp shrubbery
around your
neighbor's front lawn but the term
actually calls back to an older meaning
for the word
with a hedge being synonymous with a
fence so when we say we are hedging something
something
whether it be a literal hedging of a
herd of sheep or
figurative hedging of a specific risk it
means we are containing that thing
within a space
so that it doesn't go all over the place
that we can control its outcome
and while the term is often used to
describe financial strategies
the truth is we practice hedging on a
day-to-day basis
as mentioned by car insurance hedges
your financial risk
since you pay a premium to avoid a
larger cost you might incur
if you have a car accident wearing a
seatbelt hedges your risk of having a
serious injury
heck even heading to the bus stop early
hedges your risk of missing your ride to work
work
in each case you're taking some sort of
cost or
nuisance to avoid or prevent a greater problem
problem
whether it be financial or otherwise
when it comes to investing however
the practice refers to reducing some
sort of risk or exposure
in our portfolio it can be the risk of a
specific stock or
industry experiencing a decline the risk
of interest rates rising
even the risk of inflation being higher
than expected
this is done by adding investments to
our portfolio
that move in the opposite direction of
what we're trying to manage
in other words we're trying to achieve a
negative one correlation
to our current exposure although
technically we're looking for what's
called a negative
delta which is just a measure of how
much one asset moves
whenever the other changes by one dollar
this will ensure that if the event does
happen and our holdings lose value the
new asset will appreciate
thus offsetting the decline and
providing some protection
as an oversimplified example an investor
could hedge their exposure to a specific stock
stock
by shorting that same position by doing
this they offset their downside
if the stock falls in value the short
position will increase in value
offsetting the decline now investors
rarely seek perfect hedges like this
after all while you've avoided any
downside you've also prevented yourself from
from
achieving any gains not the smartest move
move
so investors often focus instead on
hedging specific risks or exposures
this way they aren't completely
eliminating their upside but they're
still protecting themselves from certain
losses that they don't want to have
exposure to
as an example here in canada it's common
to find currency hedged mutual funds
these mutual funds look to eliminate the
impact of changing
exchange rates on investor returns a
canadian mutual fund investing in u.s stocks
stocks
will see a lower return if the us dollar depreciates
depreciates
since the u.s money earned by the
account will be converted into fewer
canadian dollars
to avoid this the mutual fund may own
certain investments that will appreciate
when this happens offsetting the decline
and allowing investors to earn a return
similar to what they would see if they
were investing as americans
other risks an investor might look to
hedge include interest rate risk
equity risk commodity risk inflation
risk and more
but while some of these can be offset
using specific stocks or
gold in the case of inflation risk how
exactly does one
hedge against changing interest rates or
changing exchange rates like with our example
example
well it is technically possible to hedge
these risks through more traditional investments
investments
but explicit hedges are often
accomplished using what are called
derivatives we've discussed derivatives
like options and futures in the past
and i'll leave some links in the
description below where you can learn
more about each of those
but at a high level a derivative is
simply a contract
whereby you enter a bet or agreement
with another investor
about which direction some underlying
asset rate or
factor will move in the future the
underlying asset can be a commodity
a currency a stock an interest rate even an
an
index and to hedge something with a
derivative you simply bet against the
thing you have exposure to
for example for our canadian currency
hedged mutual fund
we could enter what's called a swap
agreement whereby we agree to pay a
specified exchange rate in the future
this will allow us to eventually convert
our us dollars to canadian dollars at
today's pre-determined rate
removing our exposure to fluctuating
exchange rates
another popular and enticing derivative
is the put option
a security that lets you sell a stock at
a specified price
at some point in the future when owned
alongside the stock itself
this type of option is the closest thing
you can get to an actual insurance
policy on a stock
for example imagine you have a share of
plain bagel co worth 50
and you buy a put option with a strike
price of 45
this means that no matter what the stock
price falls to you can sell that stock
for 45
even if that share becomes worthless
you've entered an agreement where you
can sell to someone else
for this predetermined price pretty cool right
right
and derivatives let you do a lot of
really other interesting things with
your holdings
for example it's possible to hedge your
market risk while still maintaining
exposure to specific stocks this is
technically done by shorting an
index feature such as the s p 500 by
doing this you negate the impact the
stock market decline would have on your portfolio
portfolio
while still having equity exposure now
this probably sounds like a
strange and not very practical tactic
but strategies like these are
actually fairly common among hedge funds
which are a special type of fund that only
only
accredited or basically really wealthy
investors can access
you see hedge funds frequently long some
assets while going short others
with the intent of earning a return
regardless of what the market as a whole
is doing hence the name of the fund and
while these vehicles aren't
accessible to everyday investors
individual investors can theoretically
carry out the same strategies
by buying their own options shorting
certain positions and altering the risk
return features of their portfolio as a whole
whole
but should they well it depends
if you want to make an active call about
certain risks and feel like you have the
expertise to do so
then by all means but hedging isn't the
godsend you might expect it to be
and there are some cons that you should
understand before you go ahead and start
customizing your portfolio
first of all hedging can be a really
complicated strategy to maintain
depending on the risk you're trying to
hedge you'll need to calculate one of
the greeks
a series of measures including the
aforementioned delta
that gauges your exposure to different
risks and the problem is that these
measures change
every time the underlying changes i'll
leave a link in the description below
where you can learn more about that but
the point
is that if you want to keep a consistent
hedge you'll need to continually adjust
your positions
which can be difficult and time
consuming derivatives can also be very
risky investments to work with
options and futures can sometimes
actually add risk to the portfolio if
you don't know how to manage them
properly so that needs to be taken into
consideration as well
secondly most hedges are only temporary
put options
futures and swaps all mature or expire
at some point in the future
so maintaining the hedge over time
requires continually rolling your money
into new positions and this is a problem
when you consider the final point
hedges in one way or another can be costly
costly
either you'll be paying an explicit
premium like with an option
paying a price that's incorporated in
the contract itself like with the future
or hedging your upside along with your
downside if you use a swap
derivative to hedge currency risk for
example sure you eliminate your
downside of the us dollar depreciating
but what if it appreciates
in this case you'd be kicking yourself
for taking a hedge when you could have
made more money otherwise
the problem too is that the more likely
you are to benefit from
using a hedge like an option the more
expensive it becomes to set up
in this way the premiums you pay on
options are a lot like insurance premiums
premiums
the riskier you are the more you'll have
to pay insurers
to protect yourself so while you may
avoid a big drop in a stock with
something like a put
option you won't be in a much better
situation if you paid a small
fortune for the protection so while
there's nothing wrong with buying
something like a currency hedged etf
or investing in certain stocks to limit
your risk exposure
trying to augment your entire portfolio
to protect you from likely declines can
be complicated
time consuming and expensive especially
when using derivatives
hedges can also limit your return
potential after all higher returns
requires higher risks it's near
impossible to earn a decent return
while bubble wrapping your portfolio
this isn't to say that you shouldn't
manage your risk
quite the contrary but most investors
can achieve the necessary risk
management by focusing on the long term
employing proper asset allocation
diversifying their holdings and
quite frankly just being smart with the
companies they invest in
so explicitly hedging your portfolio
isn't a necessity
but it's still a handy topic to
understand when it comes to analyzing companies
companies
because while hedging is considered an
advanced strategy for investors
it's more commonplace for corporations
who frequently use derivatives to hedge
their operational risks
so maybe you won't be shorting the s p
500 or buying oil futures anytime soon
but next time you're reading through a
company's filings keep an eye out for
their hedging strategies
you may just realize that your holdings
are doing all the hedging work for you
thanks for watching
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bagel my name is richard coffin
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