Sunday, May 1, 2011

The Unintelligent Investor's Definition of the Week: Hedging


Oxford Dictionary definition: protect (one’s investment or an investor) against loss by making balancing or compensating contracts or transactions.

Unintelligent investor’s explanation:

Just as the Oxford dictionary has beautifully defines, to hedge is to protect yourself against loss. I think any investment bank or fund and most companies hedge themselves against various types of losses. Plus, they can hedge themselves against almost anything. Insurance companies can hedge themselves against bad weather by buying certain options, coal companies can hedge themselves against dropping coal prices by buying futures, airlines can hedge themselves against raising fuel prices by buying options. Banks can hedge against bad debts by doing credit default swaps. They can hedge against the dropping US dollar by buying gold or against inflation by investing in REITS. We can hedge ourselves against loss of income due to injury by buying an income protection insurance policy. And the list goes on.

Maybe the best way to get our heads around hedging is by thinking of it as an insurance policy. I’m sure most of you have bought some sorta insurance policy in your lifetime; healthcare insurance to protect you in case you get sick, car insurance in case you get into an accident. For the price of the premium that you pay and the excess, you get to hedge against whatever your policy protects you from. If you don’t get sick or get involved in an accident, well you lose money in the form of that premium that you have already paid.

So if hedging protects your portfolio against losses, why not hedge against everything? Well simply because it would cost way too much. Imagine as a teenager, buying your first car, how much was your car insurance premium then? Can you still afford to buy a life insurance after paying for your car insurance? Is it worth buying life insurance at that age? I don’t know what do you think?

I think it all comes down to risk management. If you hedge too much, you eat into your net profit, if you hedge too little, you put a big chunk of your portfolio at risk of big losses. It is very much a balancing act that takes years of experience to learn or master (if possible).

So if your portfolio hedged from certain risks? It is worth thinking about hedging at our level of knowledge or exposure (which is minimal)? Do leave me comments or send me emails, I am more than happy to read about what you think, even if you think the post is totally crap, let me know.

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1 comment:

  1. Ming Wei Chin: i'm gonna comment here.. hedging is an interesting concept i think... everyone buys insurance some way or another it protects you from a lot of things, ie death or wat not... however, there is still a small fine print more often than not... for eg ur insurance doesnt insure earthquake lets say... so it really is a hmm.... y not case... i am hopin you write abt that sum time or aother... thx
    01 May at 19:27 · Like

    The Unintelligent Investor: I'm sure if you pay enough some insurances will insure you from earthquakes. And thats sorta what I was trying to say, is it worth paying that extra to cover yourself for earthquakes? or is it better to just hold the cash. Thats the balance we have to find in our other investing decisions i guess
    A few seconds ago · Like