Any savvy investor worth their salt is aware that diversifying your portfolio is a key way to reduce your risk. You might have also heard of the concept of ‘hedging’ your investments, which is a method of reducing the risk of declining prices in an investment. A ‘hedge’ position usually refers to an something which offsets your original investment, acting as an insurance policy against capital loss in the overarching portfolio.
When you own a home, you take out home insurance, covering the risk of theft, criminal damage, acts of god and so on. That insurance isn’t free though – you pay an annual premium to hold the policy. Hedging is a similar concept, in that whilst it reduces the impact of risk, it also chips away at your potential gains over the long-term. You could buy home insurance every day of your life for fifty years and never need it. You’d have spent thousands of pounds and received nothing back. Of course, suggest to someone that they don’t need home insurance, and they don’t want to take the risk – even though the chance of your home collapsing is remote, the financial cost, if it did happen, would be catastrophic.
A good investment hedge is one which is perfectly inversely correlated to the assets you’re trying to hedge against. For example, to protect against the risk of a stock market crash, I might buy gold, which traditionally rises in value when shares fall. Or if I’m investing in a FAANG stock, I might also buy utilities. If the market for high-tech gadgets collapses, people are still going to need water and electricity, and if they pull their money out of tech stocks, they’re likely to reinvest it in stable defensive shares.
Of course, much in the same way that you could buy house insurance for years and never need it, you could pay a premium to hold your hedge and never need that! Some hedges are costly, even when markets move sideways. They usually carry an upfront cost (you have to buy the hedge), and then come with holding costs that have to be paid on a regular basis.