Hedging Investments basically means reducing or controlling the risk involved in a certain transaction. In other words, Hedging Strategies are investment positions intended to offset the potential losses that may be incurred by a companion investment.
Insurance is the best example of hedging. When we buy a house worth lakhs of rupees, we usually buy home insurance along with it by paying a small premium.
So, if something untoward were to happen to the house such as damage in an earthquake, fire, flood, etc, all is not lost. The insurance will reimburse the amount as per the risk cover taken.
A hedge does not prevent a bad thing from happening, but it surely helps in minimizing the financial loss arising out of the event.
Hedging is used widely in Stock Markets. But it is also used in hedging investments also.
In investing the techniques used to minimize the loss in case a reverse scenario happens is called hedging. We have discussed these below.
The word hedge itself loosely means a boundary, fence, or barrier. In other words, if you have a huge farm where you grow your produce, then it makes sense to invest a small sum in building a fence around it so that your crops are protected by the damage caused by stray animals.
The same applies to investments too.
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If you are bullish about an asset, you would buy those with the hope of making a profit when the prices go up. But at the same time, you are exposing yourself to the risk of making a loss if the price falls.
To prevent making a loss, you can make use of certain instruments and strategies that can help reduce or minimize your losses in case your decision backfires. And all such strategies are known as hedging.
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Correlation is a statistic tool. Usually, to create a hedge, there should be a correlation between the two entities involved. In the world of finance, a statistical measure of how two securities move with each other is known as correlation.
A perfect positive correlation (a correlation coefficient of +1) implies that as one security moves, either up or down, the other security will move in tandem, that is, in the same direction (HDFC Bank & HDFC Ltd).
Alternatively, perfect negative correlation (a correlation coefficient of -1) means that if one security moves in either direction, the other security will move in the opposite direction (ITC Stock & Budget announcement of increased duty on tobacco products).
If the correlation is 0, then the movements of the securities are said to not correlate; they are completely random.
HEDGING INSTRUMENTS or HEDGING STRATEGIES
For a person dabbling in Stocks, Futures and Options are the best hedging tools. Some of these strategies are:
HEDGING WITH FUTURES
Long Stock, Short Index
Short Stock, Long Index
HEDGING WITH OPTIONS
Long Stock, Buy Index Put Options/Buy Stock Put Options
Short Stock, Buy Index Call Options/Buy Stock Call Options
We will skip details as we are dealing with hedging in Personal Finance. Also dealing in derivative (Future & Options) should be limited to trained professionals and not small investors.
HEDGING INSTRUMENTS – used in Investments
This is the best form of hedging an equity portfolio.
Spread your investments across various stock categories such as large-caps, small-caps, and mid-caps, high beta, and low beta, defensives, and aggressors so that any adverse move in any single category does not harm your entire portfolio heavily. One can also diversify between geographies (Investing in US Stocks) or between managers (Fund managers with a different style of equity management skills).
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Here two stocks or assets which are highly positively correlated from the same industry sector are used wherein the investor goes long in one stock/asset and short in the other stock/asset.
Although it becomes a zero-sum game, the strategy can be tweaked according to one’s perception of the movement of the market. For example, if you feel that the market has a greater chance of going up, then you can buy greater quantities of Equities and short less quantity of Debt. Again – it is to be handled by professionals & when amounts are big enough to justify hedging.
Fixed deposits, bonds, liquid funds, debt funds, and MIPs, among others, constitute debt. Debt and equities are negatively correlated.
Although these are not perfect hedges, having them in your portfolio can give you a decent hedge against a fall in the equity component. Asset Allocation is the key to returns.
Investing in Gold
Gold and stocks are generally negatively correlated. So, if you have a portfolio consisting predominantly of stocks, then invest some amount in gold. Therefore, in case of stocks start to fall, the gold component of your portfolio will keep it up.
In the last decade, while the stock markets were seen giving negative returns to investors, the real estate market gave multifold returns. Hence, the role of real estate as a hedging tool against stocks should not be undermined.
But this decade especially after 2016 we have seen both equity & real estate down for the almost equal amount of time with very little correlation.
THINGS TO KEEP IN MIND – While Hedging Investments
- Hedging does not eliminate risk.
- Hedged positions will make less profit then unhedged ones.
- Added cost, brokerage & taxes, among others, need to be factored in.
- Derivative used in hedges will have a margin requirement.
- Chances that both positions incurring a loss are very much possible.
- The tax treatment for the different instruments is entirely different.
- Hedging is not advised for small investors since the extra cost does not leave much on the table. It is suitable for investments of substantial amounts.
- Engaging in hedging means reduced risk but it also means reduced profits.
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I hope the article removes your misconception on Hedging Investments & Hedging Strategies to be used by small investors. Please reach out to me through comments section below or on email madhupam at the rate thewealthwisher dot com.