How to hedge an investment portfolio

hedgingWHAT IS HEDGING?

In the financial and investment industry, hedging is the practice or lowering the risks that are inherent with a particular investment by using a variety of methods. 

You establish a position in one market to offset the price fluctuations occurring in an opposite market in order to minimize your exposure to risk.  There are certain financial vehicles that you can employ to accomplish this such as forward contracts, insurance policies, and options to name just a few.

PORTFOLIO HEDGING STRATEGIES

It’s unfortunate but hedge funds have been put in a bad light and have been associated with continually taking undue risks when investing.  In so many words, many individuals view this as blatant greed.  The practice of hedging is appropriate for reducing the downside in your portfolio while at the same time preserving any growth prospects.  Here are a few suggestions for how to hedge an investment portfolio.

Purchasing put options – this is a way to sell your options or stocks for an agreed upon price at a later date.  Should the market fall, you are able to sell them at a profit and offset your losses.  For downside protection, you can use a put option against:

  • your individual stocks
  • an index that your portfolio has been modelled after
  • a major index such as the S&P 500

Real assets – commodities, real estate, and REIT’s offer diversification as well as effective hedging.  Where commodities are concerned, you can invest in ETF’s (exchange-traded funds) or trade commodity futures.  You need to be careful when playing the commodities market as futures typically correlate with the broader economy.

Shorting stocks – this is the opposite of purchasing stocks.  The concept involves borrowing a stock and selling your right to acquire it at a later date for the current price.  You are gambling that the price of the stock is going to fall in the future.  This enables you to purchase the stock at a cheaper price in the future and then pay back your obligation while pocketing your profits from the short sale of it.  Despite the fact that there is limited profit potential, the potential for loss is unlimited.

Finally, other hedge options that you should consider are cash, bonds, and/or gold.  Gold has been bought, sold, and traded for centuries, but it is still one of the most effective ways to hedge your investment portfolio.