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How can you hedge against potential investment risks?
Investment risk is defined as the probability of an investment asset to incur loss or not achieve its expected returns. All investments have risks but smart hedging strategies could enable investors to minimise their exposure to financial risk.
How can you hedge against potential investment risks?
Investment risk is defined as the probability of an investment asset to incur loss or not achieve its expected returns. All investments have risks but smart hedging strategies could enable investors to minimise their exposure to financial risk.
Hedging has a bad reputation mainly due to how hedge funds are portrayed as high-risk investments in Hollywood films. However, its main purpose is really to minimise any negative impact caused by various risks the investor’s portfolio is exposed to.
Executing a hedging strategy is akin to buying an insurance in the sense that the investor is buying another investment asset as an assurance that they will be able to minimise losses from another asset.
Hedging strategies can be as simple as creating a diversified portfolio of assets or as complex as employing active management strategies. Regardless of the strategy used, an investor’s aim is to balance investment risks and returns and avoid complete loss of their capital.
There is no such thing as a risk-free investment, but investors may consider three common hedging strategies to minimise their exposure to risk.
These are:
- Portfolio diversification
- Futures
- Options
Portfolio diversification
Creating a diversified portfolio of assets is one effective way to hedge against potential investment risks. In portfolio diversification, an investor’s objective isn’t simply to acquire different investment assets but to ensure that one asset can make up for another’s weakness.
An example for this is to select assets according to their class and/or risk exposure.
Asset class
Shares, bonds and property complement each other, because a risk that heavily affects shares may not necessarily affect bonds even if they were both acquired from the same market. On the other hand, while both shares and bonds present a degree of liquidity that is not present in property, real estate is not directly affected by equity and bond market movements.
Each asset class presents different income-earning opportunities, but they also open up greater exposure to risks within their respective markets.
Risk exposure
Just like diversifying assets according to asset classes, investors may also compose their portfolio focused on risk exposure. That is, they may select a variety of asset classes that cover each other’s weaknesses.
In line with the example above, a property’s strength is that it is not exposed to market volatility, but physical properties tend to be illiquid. On the other hand, shares are highly liquid assets, but its exposure to market volatility can end in loss. By combining the two assets in one portfolio, the investor can minimise exposure to volatility while also having accessible liquid assets.
Bonds or fixed-income assets also complement shares and property because it gives investors a predictable amount of income for a fixed duration.
Competition within sectors
Another way for investors to hedge against risk is by investing in the underlying asset’s competition, especially in competitive sectors.
Assuming that the intended investment is in company A and the competitor is company B, the four potential outcomes when using this tactic are explained below.
- If company A’s business flourishes and the original investment increases in value, only a portion of the investor’s portfolio would increase in value because a portion of their investment is in company B.
- If the investor was wrong and company A decreases in value, they can cut their losses because their investment in company B could increase in value.
- If the entire sector falls, both investments could decrease in value.
- If the entire sector experiences a boost, the investor could reap greater benefits from both assets.
This strategy is best suited for shares portfolios.
Futures
Futures are legally binding contracts that investors can purchase as a form of assurance that they will be able to buy or sell an asset at a specified price within a given time. Futures contracts is a form of hedging against risk because exercising them obligates an investor to buy or sell an investment asset according to the contracted terms, regardless of its current market price.
Consider a situation wherein company A’s current share value is at $20 per unit and Steve owns 100 units – a total value of $2,000. Steve could buy a futures contract issued by company A that indicates it will buy 100 units of company A shares for $18 per on 31 December 2018.
If the value of company A shares plummet to $15 per share on 31 December, the contract would force company A to buy back his 100 shares for $1,800 instead of $1,500, which is the current market value. Doing so would prevent Steve from incurring a bigger loss.
However, it also works the other way around. If the value of company A shares rise to $25 per unit or $2,500 for 100 units, Steve would be forced to sell his shares for $1,800.
Options
Options work like futures contracts, but it does not obligate the contracting parties to buy or sell the contracted asset.
That is, while there is a deadline and an agreed price to buy or sell the investment asset, either party may still back out of the deal when it is exercised. Likewise, the decision to exercise the option depends on the option holder.
If, in the example above, Steve purchased an option instead of a futures contract, he may opt to let the contract expire if the value of company A shares increase above the premium price he paid for the option.
Hedging strategies can be complicated
Investors are advised to ensure that any hedging strategy they plan to execute is appropriate for their portfolio. If in doubt, it’s best to seek the advice of a licensed professional who can make appropriate recommendations according to the investor’s objectives and circumstances.
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