Hedging in Investing

During the crash of 2008, some of the bad guys we heard about in the press were "hedge fund managers." Most of us have no idea what a "hedge fund" does, but we know it's something that people with way more money than us do. In fact, hedging is an important part of investing and something even small investors should think about.

What is Hedging?

Hedging, at it's most basic, is the act of making an investment to offset another investment in your portfolio. Let's say you own a lot of Apple stock and are a little worried that you're over-exposed to the technology sector. You figure, if there's another dot-com crash, your Apple stock is going to crash right along with it. Maybe it would be best to reduce the exposure to technology in the portfolio. What we're talking about doing here is "hedging" our Apple position.

Hedging Example

We talked earlier about shorting stocks, and this is one of the most common ways to hedge a position. In our Apple example, we might now go and short shares of Google to reduce our exposure to technology. Once we've shorted Google, if the technology sector crashes and everything goes down, we'll actually make money on the shares of Google we shorted, which will offset our losses in Apple. Thus we've reduced our risk in the case of a technology crash. Of course if Google goes up and Apple goes down, we'll regret that decision.

Hedging as Insurance

Hedging doesn't have to be shorting stocks. You might also invest in something that tends to move in the opposite direction of the position you're trying to hedge. Let's say we're worried about stock exposure. We might buy some government bonds, which generally tend to move in the opposite direction of the stock market. Thus if our stocks go down, our bonds will hopefully go up -- and vise versa.

Zero Sum Game?

All of this may sound like an expensive way of doing the same thing as not investing. If I'm going to lose money in Google whenever I make money in Apple, why bother? The answer is about managing risk. What you're basically saying when you buy Apple and sell Google short is that you like Apple better than Google, but don't want to be too exposed to the technology sector. If Apple goes up more than Google, then you'll make money; and if Google goes up more than Apple, you'll lose money. But if there's a catastrophe and the market crashes or a tech-bubble pops, you're much safer than you would have been without your hedge.

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