Do you know how much money I spend on insurance? Of course you do because you do too. Auto insurance, health insurance, disability insurance, life insurance, pet insurance, and homeowners insurance just to name a few. Insurance protects us from being wiped out financially. We pay a lot of money for insurance but our insurance doesn’t exactly correlate with the money we make. If you make $50,000 per year, you don’t pay $50,000 for insurance. You pay a smaller amount to protect yourself from loss which allows you to earn a living.
If you understand this concept, you understand the concept of a hedging. Hedging is something investors do as a form of insurance against loss. If you diversify your portfolio you are already familiar with the most basic form of hedging. If you put all of your money in to one stock and it takes a serious downturn, you lose most of your $5,000. If you invest $1,000 in Exxon, $1,000 in Apple, $1,000 in Morgan Stanley, $1,000 in 3M, and $1,000 in GE, it’s unlikely that all of your stocks will go down. Instead, some will go up while others go down so you never lose it all. (Remember, though, that you only lose money if you sell. If you are holding on to stock for years or decades, hedging is less important.)
Diversification is the most basic example. More seasoned investors hedge by doing something called short selling. Short selling is when you invest in a stock in a way that makes you money when it loses value. If you want to invest in the banks, you may buy 100 shares of JP Morgan Chase and buy 75 short shares of Goldman Sachs. (Technically, we would sell short 75 shares but let’s not worry about the right wording right now.)
We have now hedged. If both banks go down, we make money on Goldman Sachs and lose money on JP Morgan. If both go up, we make money on JP Morgan Chase and lose it on Goldman Sachs. Of course they may go in opposite directions. Now that you’re an expert at hedging, you can figure out the math with that.
Short selling is not for the beginning investor. It’s an advanced strategy not for the student. There is a slightly safer way to hedge although it’s still recommended that you don’t get involved in this strategy until you have some experience in the market. There are ETFs called leveraged ETFs that are called short ETFs that follow certain sectors of the market that make you money when the market goes down. If you are interested in reading more about these, take a look at the ProShares funds. Again, please master basic stock investing before investing in something like this. It’s particularly dangerous because “leveraged” means that they move in double the amount of the market. In the most basic terms (and not mathematically accurate) if the market goes down 50 points, you make $100. If it goes up 50 points you lose $100. You can see how the potential for lose is quite large.
Although some of the get rich quick programs out there will tell you that hedging won’t make you much money, you must hedge. If the best of investors make it a priority to be hedged, you have to be as well. As a beginning investor, your best way to hedge is to diversify. If you want to get rich quick, play the lottery. Don’t get involved in the stock market.
In a coming article, we will discuss hedge funds and how they work. You already know the basics of how they work because you understand hedging. Now, take a look at your portfolio and make sure that you’re hedged.