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 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 in this post.
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, 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. In each case you're taking some sort of cost or nuisance to avoid or prevent a greater 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 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 achieving any gains. Not the smartest 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, 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 will see a lower return, if the us dollar 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. Well it is technically possible to hedge these risks through more traditional investments. But explicit hedges are often accomplished using what are called derivatives.
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 index. And to hedge something with a derivative you simply bet against the thing you have exposure to.
For example, for 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 company A worth 50 dollars 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? 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, 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 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. 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.
Ffirst 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 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.
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, 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. 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. 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 reading if you have any feedback or topics you want me to cover in the future, leave a comment down below.
Now it's a bit of a stretch to say that building a website is like hedging, but here it goes. Having a website is a great way to get your name product or service out there and without a page for interested customers or followers to visit, you risk missing important exposure that could benefit the work you do. Which makes Squarespace an excellent hedge in the circumstance. You know what maybe it's not a great comparison. but hey i want to give it a shot anyway. Squarespace have a website builder that is an all-in-one tool that you can access from any website browser. meaning you don't have to download anything to edit your website on top of this if you're overwhelmed with the prospect of building and designing a website from scratch, they have plenty of pre-built templates that you can pick from that already look amazing making it easy to quickly drop in your own content.
If you have a business that you're trying to operate, You can set up an e-commerce page schedule appointments and much much more on squarespace and the best part is that you can try their page builder yourself for free. meaning you can put everything together before launching without paying a cent. check out Squarespace and start sharing with the virtual world today.
Comments
Post a Comment
If you have any questions comment below