A hedge is an investment expected to offset a potential loss in another investment in the same portfolio.
Investors have a variety of tools available to them to manage the risk in their investment portfolios. Diversification, which is owning in a lot of different investments, is one. Another is choosing investments with different levels of a volatility and rebalancing them periodically.
Still another way is to hedge your investment strategy by owning an investment likely to perform very differently from the main portfolio. For instance, if you own mostly stocks, a hedge might be to own an exchange-traded fund (ETF) designed to go up when markets fall.
There’s no guarantee that your hedging idea will work as you expect, but a perfectly hedged portfolio should provide the upside of capital appreciation without the accompanying risk implied by those investments.
Of course, the very idea of hedge funds is to institutionalize the practice of hedging one’s investments. By freeing up the manager to pursue unorthodox investment ideas, hedge fund investors expect to participate in a rising market while losing less in falling market.
That sounds great, but the reality is a little less rosy. Hedge funds have had a tough time proving their worth to investors. That’s in part due to a limited amount of true investment talent but also just a fact of life when it comes to markets — that some are winners means that some will be losers.
Hedge funds operate in secret. Even their investors are kept in the dark. That doesn’t mean, however, that their methods are unknowable. Over time, savvy market observers learn the tricks of the successful funds and begin to replicate their approach.
More investors doing the same thing tends to weaken the effectiveness of that strategy, so hedge funds have to innovate constantly to stay ahead.
Secondly, as a hedge fund grows, it takes on more and more investor money. Eventually, they can get so large that they cannot trade without the entire market taking notice almost immediately. Secrecy becomes impossible.
For the typical retail investor, the costs of hedge funds easily outweigh any perceived advantage. Using off-the-shelf tools to hedge on your own, such as options trading or derivatives, can be high risk.
Moreover, trying to choose specific investments over others based on your ideas about the economy, earnings and the flow of investment news introduces yet another layer of risk: being wrong. Market timing works until it fails, and then often it fails spectacularly.
The long-term investor trying to reduce portfolio risk is usually better off reducing the risk of their own emotional overreactions to changes in investment values.
For instance, if you know for a fact that you can completely ignore a significant decline in the stock market, you don’t need to hedge at all. Your investments are safe from you, which is the source of most investor losses — emotional decisions made under pressure.
If you cannot avoid the temptation to watch your investments, then a balanced portfolio of low-cost index funds can go a long way toward reducing the overall volatility of your investment. That in itself will lower your anxiety and the risk of you taking action at the wrong moment.