How to Hedge your Portfolio

What does it mean 'to be hedged?" Wikipedia defines a Hedge as "an investment that is taken out specifically to reduce or cancel out the risk in another investment. Hedging is a strategy designed to minimize exposure to an unwanted business risk, while still allowing profit from an investment activity".

A properly diversified portfolio is hedged, in the sense that if one sector within the portfolio goes down in price, another goes up to balance it out. It is common for bonds to be recommended to balance a stock portfolio. Sometimes though, these move in tandem. We have recently passed through a period of asset inflation in which all types of investments - stocks, bonds, gold, real estate, commodities - all went up together. Typical asset allocation techniques of diversification don't work under such conditions.

There are investments, called Inverse investments, that are specifically designed to do the opposite to another investment. For example, you might hold the Dow Jones Index and an equal amount of the inverse of the Dow Jones Index. When one goes down, the other goes up by an equal amount, thus canceling out both the risk and the reward of holding the Dow Jones Index. We have achieved the hedge, but have lost the opportunity to profit on our investment.

Another hedging tool are options. These are commonly thought of as speculative investments, and thus to be avoided. Their original purpose though was for hedging. They are a form of insurance policy. If the stock goes down, the value of the 'Put' option goes up. Like most insurance, the cost is small compared with the potential payoff, but the chances of the payoff are also small, making them somewhat unreliable unless used with skill and care. This rules out their use by the great majority of the investing public. They are a key part of the strategies of hedge funds, but some big professionally managed hedge funds have failed due to misusing options.

What's left? Here's an idea called 'Pairs Trading'. You buy a strong stock, and sell short the same dollar value of a weaker stock in the same sector. If the sector does well, both stocks will go up, so you will have a loss on the (weaker) stock you sold. However, the stronger stock should have gone up even more, leaving you will a profit. Similarly, if the market goes down, both stocks will fall in value, but the weaker one will fall the more, again leaving you with a profit of the difference between their two performances.

In the right hands, and used at appropriate times, all the methods of hedging described here will work to protect you from the worst of a down market. Call if you would like to learn more.

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