Investment hedging is any method that reduces or eliminates investment risk. It usually ends up working like insurance. It offers protection against a negative event at a cost. The negative event is not prevented from happening but its effects are reduced.
Take car insurance for example. When you buy it you are hedging yourself against accidents and theft.
You don’t really want to buy the car insurance, you just want to buy the car, but you buy the insurance just incase something bad happens to the car.
Most of the time, the insurance simply costs you money, but if you are lucky (or unlucky depending on how you look at it), your car might get stolen, allowing you to claim on your insurance.
Hedging a particular investment is pretty similar. You invest in something you want to, that you think is going to provide you with good returns, and at the same time you invest in something else that offers some protection just in case something bad happens to your investment.
It can get pretty complicated if you want it to. Alternative investments, forward contracts, swaps, options, derivatives and futures can all play their part in hedging strategies.
But hedging doesn’t have to be so complicated. Really, it just involves purchasing investments that move in opposite directions to one another.
More stocks please
Investing in different stocks is a form of hedging if you think about it. If you really knew a particular stock was going to sky rocket you could just whack all your money in that company.
The trouble is we can’t be sure. Check out the chart below which compares Google (Alphabet inc) with the wider US stock market (the S&P500) from 2005.
Google vs the US stock market
Source: Portfolio Visualizer
During that time period investing in Google turned $10,000 dollars into $123,715, compared to investing in the wider US stock market (S&P 500) where your $10,000 would have turned into just $32,207.
Google grew at 18.71% per year, compared to 8.3% for US stocks. To put it another way, Google trounced the wider US stock market.
Google still seems to hold a strong competitive position. With cloud storage, the Android mobile operating system, YouTube and a search engine that dominates the globe, the company looks like it still has a pretty strong competitive position.
I bet there are a lot of people out there that think there’s a pretty good chance Google shares are going to beat the wider stock market for the foreseeable future, but don’t invest all their money in it.
Who knows what the future holds?
So why don’t they just invest all their money Google now? One reason comes down to the fact that they can’t be sure Google is going to continue to outperform the wider stock market. Who knows what the future holds? What if something unforeseen happens?
To avoid something unpredictable happening at Google impacting their pensions, sensible folk invest in other companies that they don’t have as much faith in alongside the one or ones they really like. That way if Google stops growing so fast or worse still goes bankrupt, they won’t lose all their money.
In fact, if they invest in lots of different companies, one business going bankrupt should hardly make a dint in their investment portfolios.
That said, if nothing bad happens to Google, and instead is grows to further dominate the world and the stock price continues its accent, they’d have been better sticking with the one stock.
Investing in other stocks will have watered down returns, and in doing so cost money.
Investing in other companies is like an insurance for if something goes wrong with the Googles of this world.
Using international markets to hedge
Google is just one of a group of US stocks like Apple, Microsoft, Amazon and Facebook that have dominated stock markets in recent years, and have contributed to US stocks dominating the globe.
In fact, in just the same way Google has put the wider US stock market to the sword, US stocks have left the rest of the world in the rear view mirror.
No matter whether you look at the recent few years or the full 200 years for which we have data, there’s no doubt about it, US stocks have outperformed the rest of the world.
There’s a good argument for just sticking your entire net worth in them, but lots of people don’t, and that’s because they fear (or hope) things change somewhere down the line.
The chances are US stocks will underperform the rest of the world at some point.
It follows that for a lot of people keeping international stocks in their portfolio is a hedge against the current situation changing in the future. So there’ll be plenty of investors (especially Americans) who don’t want to invest in foreign stocks, but who do it just in case.
Bonds
Even Americans who stick with US stocks are more than likely hedging through their ownership of bonds, especially government bonds.
Investing in government bonds is a kind of hedge. You buy stocks because you want high returns, but you also buy government bonds because you know that they tend to go up, when stocks go down.
Never can that be more true than right now when lots of bonds around the world have negative yields.
Even when all the bond yields are positive, stock returns usually outperform bond returns which means you are effectively sacrificing investment returns, by having bonds in your portfolio.
And because investment returns equate to money, you are essentially paying to have bonds in your portfolio.
You are paying for something you don’t really want, just in case the thing that you do want runs into trouble.
Splitting between stocks and bonds is a tried and tested method used by lots of investors to hedge stocks in their portfolio.
The only real decision you need to make is how much of your portfolio should be in stocks and how much should be in bonds. (This is a big decision, which you can read more about here).
Using gold or put options
Gold works in an investor’s portfolio in a similar way to bonds.
It is a drag on your portfolio in the good times and is thus costing you money, but if something really bad happens in the world, it may go up in value dramatically, and thus counteract plummeting stock prices.
(The advantages and disadvantages of gold investing are covered in more detail here).
Lots of investors like to keep a dash of gold in their portfolio’s to help them sleep at night.
Another common alternative, is purchasing put options. A put option is an option contract that gives you the right to sell a specified amount of some underlying security at a specified price within a specified time frame.
In other words puts increase in value if the underlying stock price decreases, which protect your portfolio against stock market downturns.
If you pick the right put option, the more stocks fall, the more your put should increase in value. If your stocks decline 20 percent. Your put option would rise twenty percent. Sounds perfect, but the main drawback of this strategy (like the others) is that it costs money to implement.
(This idea is taken to the extreme with tail risk strategies that you can read more about here).
I’ve mentioned a few of the main methods you can use to hedge but in reality you find people hedging all kinds of things with all kinds of other things.
Ray Dalio
Personally, I like the story about billionaire Ray Dalio, the founder of the largest hedge fund in the world, Bridgewater Associates.
In his early days he helped McDonalds launch chicken nuggets. McDonalds were eager to stick chicken nuggets on the menu, but were held back, by chicken price volatility.
Though suppliers wanted McDonald’s business, they weren’t prepared to fix the price because at the time the chicken price was all over the place.
McDonalds feared that if they bought chickens without a fixed price they may have to raise prices to unsustainable levels or even lose money if prices rose, so they turned to Ray for a solution.
In an ideal world, McDonalds could have just hedged Chicken prices, but at that time the chicken market wasn’t big enough to hedge, so Dalio had to come up with an other idea.
Dalio realized that chicken prices were directly related to chicken feed, so they could hedge any price increases by buying corn and soymeal via the futures market.
A futures contract is an agreement between two parties that something will be purchased or sold for a specific price on a specific day in the future. Like an option but without the optionality!
Essentially, the chicken farmer could guarantee that she could buy her feed at a certain price in the future, and could then offer McDonalds fixed prices.
Currency hedging
Apart from news stories about hedge funds, most investors won’t often come across the word hedge, unless their financial advisor mentions currency hedging. After all, you don’t have to be trading FX to be investing in international currencies.
In reality, if you invest in stocks, whether individually or through a fund, in all likelihood at least some of the companies you invest in, will do their business in other countries.
This has benefits, because it means your investments aren’t wholly tied to the country where you live, which ads diversification to your portfolio.
If the British economy hit a wall and you were totally invested in UK companies that only did their business in the UK your investments would hit the wall too, but if you invest in foreign companies or at least UK companies that do their business abroad, your investments should suffer less of an impact.
Currency risk
But when companies do business in other countries they do so in other currencies and this brings with it currency risk. Let me explain.
If somebody living in the UK and somebody living in the US each bought a $100 dollar bond which pays $1 a year, they would both be sure to have $101 after one year.
For an American the value of $101 dollars is unquestionable. It is $101! For somebody living in the UK however, the value of $101 dollars must first be exchanged into pounds before the true value can be assessed, and here lies the risk.
Right now, the exchange rate is about £0.8 to $1 so $101 dollars is about £81. We would expect to receive £81, but what if the price of the pound moved against the dollar.
If the pound strengthened against the dollar so that $1 was worth £0.6, then $101 would only be worth about £61, which would be terrible for an investor. They’d have lost about £20.
Currency exchange rates can be pretty volatile. During the Brexit vote the pound dropped 10% compared to its high against the dollar in a single day.
That said, this volatility isn’t always a bad thing. It can move in your favor. Take our example above. If the value of the pound weakened against the dollar and £1 became equivalent to $1 then $101 would be worth £101, which would be great for an investor because they would have made about £20.
Currency volatility is also more of a short term phenomenon than something longer term. Over the long term these currency fluctuations tend to even themselves out meaning with a long term time horizon long term unhedged and hedged investments should provide similar returns.
In other words, if your stock investments are long term you probably don’t have do worry about currency hedging and anybody who invests in stocks should have a long time horizon because in the short term stocks can go down big time!
Bond currency
You’ll notice I said stock investments. The bond situation is a little different because investors tend to see bonds as the safe stable component in their portfolio.
As I’ve already mentioned most investors have bonds in their portfolio as a hedge against falling stock prices.
The best bonds to use for this are developed market government bonds. Examples being US, UK and German government bonds. These move in the opposite direction to stocks, and most importantly have a tendency to go up when stocks crash.
So when investing in government bonds investors have three choices: those of their home country; those that are hedged, or; those that are unhedged.
I’ll tackle these in reverse order. Unhedged international bonds may be OK for investors who have a long time horizon and understand that in the short term prices could move up and down dramatically or for those investors that don’t have investment grade government bonds where they live or that move around a lot.
Hedged international bonds may add a little diversification to the fixed income side of an investors’s portfolio, but not much because the hedging reduces this.
The international bonds become much more like the home currency’s bonds. And the thing is, they come with a cost, which subtract from investment returns, and mean hedged tends to underperform unhedged. That is to say that you are paying for reduced diversification.
You can read more about hedging bonds here, but generally for these reasons investors are going to be better sticking with high quality government bonds from their home country if available.
At the end of the day these will be denominated in the currency they are going to be spending their money in when they cash out, which means they aren’t exposed to currency risk at all.
The bottom line
There are lots of complicated strategies out there to hedge your investments, but a well diversified portfolio of stocks and bonds implemented through low cost index funds should provide investors with all the investment hedging they are eve going to need.