Managing risk as an investor is an important part of making sure you don’t end up losing more than you can afford to. Using a hedging strategy can help you offset some of the risks inherent in your stock portfolio. Every investment comes with risk, but that doesn’t mean you have to accept that you might just lose out. Here are some of the basics of hedging, as well as some of the strategies you can use to make a little money while offsetting some of your risks.
Key Takeaways
Do you know what portfolio hedging is?
Do you know how to protect your money?
Why taking a risk is good
What is a hedging strategy?
A hedging strategy is a way to help limit your losses when it comes to investing. In your regular finances, buying insurance on your car is an example of a hedging strategy. You are worried that getting in an accident will damage your car and you will still have to pay off the remaining loan balance plus buy a different car.
If you have insurance, there are still costs, but you have limited your losses. The insurance can pay off the loan balance and potentially provide funds for you to buy a different car. With investing, there are different strategies you can use to limit losses — or even make money while being a bit risk-averse.
Portfolio hedging strategies
Derivatives
When many investors think about a hedging strategy, derivatives come to mind. You might be long on a specific stock but worried about short-term volatility. So, you invest in the stock but buy a put option. If the price falls, you still have your shares in the company, and short-term losses are offset by the profits from the put option.
Options and other derivatives, including futures, are considered riskier than other hedging strategies. However, they can be useful in offsetting short-term losses for assets that you hold.
Arbitrage
With this hedging strategy, you buy an asset in one market and then sell it another. Arbitrage trading is about finding an asset with price discrepancies and then buying it so you can turn around and sell it for more in a different market.
Dividend reinvestment
Rather than using dividends as income, you canuse dividend reinvestment as a hedging strategy. You receive more shares when you reinvest dividends. This helps you grow the number of shares in your portfolio. Plus, if the stock price happens to be down when you buy additional shares with the reinvestment, you can get even more bank for your buck.
Over time, the compounding returns on the shares you own due to dividend reinvestment can give you a wealth boost. This helps offset short-term losses you might have had to take at some point.
Cash
By keeping some money in cash, you can protect against portfolio losses. Some investors use this hedging strategy by taking profits when it appears an asset bubble is forming. They keep a portion of those profits in cash, locking them in and retaining access to cash during a downturn.
One way of using cash as a hedge is to make use of thebucket system. With this approach, you consider how much cash you think you will need for two or three years. You sell high-performing assets and keep the cash available. That way, if a market correction means losses, you have enough cash to see you through the downturn so you do not have to sell assets when they are low.
By using this approach, you move money between buckets, depending on your needs, so that you reduce your risk of selling low.
Diversification
Portfolio diversification can also help you reduce your chances of loss. This includes holding different asset classes, including a mix of stocks, bonds and real estate. Some investors like adding alternative investments, like tax liens, commodities and cryptocurrencies to their portfolios. Because some assets rise as others fall, this diversity allows you to capture different profits from various assets. Plus, you are less likely to have every part of your portfolio lose value at the same time.
It can be difficult to determine which assets are “safe” since quantitative easinghas distorted asset prices. Even with this distortion, though, diversity can still be a useful hedging strategy for your portfolio.
Income-generating and inflation-protected assets
By adding income-generating assets to your portfolio, you can hedge against losses. Bonds are considered “safe” and they provide you with interest income. You receive this income no matter what’s happening to bond prices. Inflation-protected bonds, such as those issued by the U.S. Treasury, can also help you hedge against inflationrisk.
Other income-generating strategies, like investing in multi-family rentals and cryptocurrency yield farming can provide a revenue stream that can make up for short-term losses in assets.
Learn to take a risk
Using one or more hedging strategies to help limit your losses can be an important part of portfolio management. However, in some cases, you need to learn to take a risk in order to overcome potential losses.
Every action you take as an investor comes with some type of risk. Keeping your money in cash and using government bonds come with inflation risks. Your buying power in the future is at risk when too much of your portfolio is kept in the investments considered safest.
By taking calculated risks with a portion of your portfolio, you can grow your wealth over time. Learning what works best for you and allocating your portfolio is an important part of your overall hedging strategy. Identify different downside risks and look for ways to offset them.
Conclusion
Your portfolio has risks due to the nature of investing. Each asset class you have, and each move you make comes with some level of risk. When creating an investment strategy, understanding these risks — and how to hedge against them — is an important part of long-term success.
Do not forget to build hedging strategies into your portfolio. There are various methods you can use. Consider using between two and four hedging strategies that make the most sense for you and your asset allocation. That way, you will be able to handle downturns more effectively — without the need to liquidate the assets that are underperforming in the short term.
Miranda Marquit, MBA, has been covering personal finance, investing, and business topics for the better part of two decades. She has contributed to numerous outlets, including NPR, Marketwatch, U.S. News & World Report, and HuffPost. She is an avid podcaster and the co-host of the Money podcast at Money Talks News. Miranda lives in Idaho, where she enjoys spending time with her son playing board games, travel and the outdoors.
Miranda Marquit, MBA, has been covering personal finance, investing, and business topics for the better part of two decades. She has contributed to numerous outlets, including NPR, Marketwatch, U.S. News & World Report, and HuffPost. She is an avid podcaster and the co-host of the Money podcast at Money Talks News. Miranda lives in Idaho, where she enjoys spending time with her son playing board games, travel and the outdoors.
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