Hedge

Common parlance tells us in simple terms what an investment “hedge” is. When we “hedge our bets”, we aim to limit their downside risk; it is just so in investment terms. But while what hedging means is simple enough to understand, actually implementing hedges (or indeed a whole hedging strategy) can be anything but.

One way of hedging would be to look at your investment strategy and then, with a proportion of your portfolio, take an opposing view on the investment environment as a whole, a sector or even particular security. That way, if you are broadly favouring cyclical stocks, for instance, the countercyclical stocks you have backed act as a kind of insurance policy.

It is clearly rare, however, to find a perfect hedge, meaning an investment which is completely inversely correlated to the asset one is concerned about. Therefore, much hedging is actually carried out through the use of derivatives. These include a range of options and futures contracts where a relationship between the prices of assets – and timeframes – may be set out to give a higher degree of certainty over the investment risk being contained. As you might expect, this comes at a price.

The amount you dedicate to the hedge (and how you implement it) have to be very carefully calibrated indeed. It is easy to see that if you were to simply take equal and opposing views on every investment call, you would run the risk of cancelling out any potential gains completely (and incur investment costs beside). Yet even aside from such extremes, one must always bear in mind that hedging positions of any size will eat into potential returns – and also that hedging has differing levels of merit in different cases. Insurance policies always carry a cost and the risk they are insuring against has to be worth the expense and trouble of taking them out.