Most investment decisions boil down to the simple question of how much risk the investor is willing to take, and therefore, it is important to be able to manage such risks when they are taken. Hedging is an umbrella term used to describe any sort of strategy that helps mitigate investment risk.
The most common and well-known hedging strategy is derivatives, but we do also get buying and selling strategies that can be used to build hedging into your investment portfolio helping to manage the overall risk, which we will unpack in this article.
Diversification
The saying “don’t put all your eggs in one basket” never gets old, and it is just as true in the financial world as it is on the farm. Diversification may not be an exciting approach but it is a foolproof strategy to lower risk in your portfolio.
Diversification is when an investor puts his funds into investments that don’t move in a uniform direction meaning they are not correlated. Simply put, it is investing in a variety of assets that are not related to each other so that if one of these investments declines, the others may rise.
Investors may want to diversify by investing in different companies, in different industries, over different asset classes or even geographies. Diversifying your portfolio means that any shock or risk that may negatively impact one or a few of your investments may have a less severe impact on your overall portfolio if some investments aren’t impacted, or even benefit from the event.
Although correlation between investments continues to change as market patterns and movements are constantly adapting, there are some general principles to bear in mind when considering which asset classes to include in your portfolio to add diversification.
Gold and the US Dollar are considered to be “safe haven asset classes” and will retain or increase in value if global uncertainty and volatility put pressure on most other asset classes. Gold in particular is considered a safe haven asset class since it has finite supply meaning it can keep its value despite inflation causing cash to lose value.
The US dollar on the other hand is also considered a safe haven asset class due to its position as the world’s reserve currency and the fact that most international transactions are denominated in US Dollars.
Defensive shares have historically also been considered to be a good diversification hedge in a portfolio since such companies continue to prosper despite economic downturns. Examples of defensive stocks are healthcare companies and utility stocks, since people will still need to buy such goods despite difficult times.
On an industry level impacts such as changing interest rates can also have different impacts on different industries. Increasing interest rates may cause banking stocks to benefit while consumer stocks decrease. For this reason, it is advised to invest across a range of different industries when building a portfolio.
Average down
The average down strategy is when an investor buys more units of a particular share or investment that is already owned, when the price is falling. This hedging strategy helps to lower the average price for which the share was bought with the goal of making a bigger profit when the share price increases again. In effect the profits from the second buy are used to offset losses in the first.
This strategy is usually implemented when the investor has reasonable reason to believe that the sell-off is not due to serious problematic fundamentals in the company that they are investing in, but rather due to an overreaction by the market. Although the strategy can be implemented by short-term traders it is usually used by longer term investors.
The risk profile of a company where this strategy is applied must be adequately assessed to ensure that it does indeed lower risk rather than increase losses.
Staying in cash
This strategy is as simple as it sounds. The investor keeps part of his money in cash, hedging against potential losses should the funds have been otherwise invested and have been exposed to market downturns. This is however not a long-term strategy since inflation can cause the value of your cash to decrease over extended periods, but can be a valuable strategy if timed correctly when global markets are falling.
Incorporating various hedging strategies can help shield an investor’s investment against sudden and unforeseen changes in financial markets and the better they are understood the more effectively they can be used. Next week we will look at derivatives as an important hedging strategy that is also commonly used to manage risk in portfolios.
