Financial literacy is something that everyone, not just professional investors or financial advisers, need to develop in order to achieve their financial goals and build financial resilience. At Trustees Executors, we’re working to improve the financial literacy of our clients and all Kiwis. As a part of this endeavour, we’re launching a new series called “Investing Explained”, where we’ll focus on explaining investment terms and how understanding these can help you to invest better and more sustainably.
Our first topic is hedging. Many of you may have seen or heard of this term being used in financial markets with investment managers indicating that various products may be hedged and of course Hedge Funds from time to time feature in the headlines. In this topic we are focused on the first of these where strategies are used that help protect investments from outsized risks while minimising potential losses—usually at a cost. This article does not cover Hedge Funds which sit in an alternative asset class.
What is hedging?
Hedging is technically the practice of making an investment that will offset a potential loss in a related investment. It works a little bit like insurance, where you incur a cost or limit potential gains in exchange for protection from a loss, usually through the use of derivatives such as options or futures.
In more general terms, hedging can also be understood as any activity you take to protect yourself from the risks of an investment. In more practical terms, there are a few specific strategies that investors commonly employ to manage their risk.
Different ways to hedge an investment
There are many different ways to hedge an investment, both with derivatives and in more general terms.
Investors often see investment products which provide hedged exposure to international bonds and or equities. International fixed interest products are perhaps the best example. Most International Fixed Interest fund managers will hedge portfolios to reduce or eliminate the impact of currency movements. This is usually achieved by entering into contracts with banks to sell the foreign currency exposure. By doing so any change in the value of the underlying investment will for all intents be offset in the change in value of the currency contract This strategy therefore still allows the manager to access the large pool of international investments but without the increased volatility currency changes could impart. Fund managers may also adopt similar strategies for international equities. Unfortunately these strategies are difficult to access for smaller investors.
Options and futures
The use of options or futures (including contracts for differences) is more accessible.
Buying a put option gives an investor the right but not the obligation to sell an asset at a set price at a future date. This means that if the price of the asset crashes in the meantime, they’ll avoid some or all of the loss. If at the maturity of the option, the asset price is above the set price the contract merely lapses with the investors effective return reduced by the cost of buying the put option.
Selling a futures contract or a contract for difference can also be used to hedge an asset. These contracts however obligate the investor to buy or offset these contracts at a future date. This can protect the buyer from asset prices falling, but also means the contract offsets any appreciation in the underlying asset.
Keeping cash on hand
The simplest way to avoid a ruinous loss is not to overextend the resources you have available. By only putting some of their money into investments, investors can ensure that they’ll still have money left over to work with if the market were to crash. Moreover, it puts them in a position to take advantage of a slump in the markets by investing when prices are particularly low.
When a stock price falls, inexperienced investors may panic and sell. Professional investors, on the other hand, may choose to buy more. This is called “averaging down” because it drives down the average cost that the investor paid per share overall. If the stock price partially recovers, the profits from the later purchase may partly or fully offset the losses from the original investment.
The simplest and most widely known way to mitigate investment risk is to diversify your investment portfolio. That means purchasing many different kinds of assets that are unrelated to one another. As a result, a loss in any one investment will only have a minor effect on the portfolio as a whole.
Always invest with a strategy in mind
When investing, it’s always important to understand both what you are investing in and how your investment strategy will support your financial goals. That often means not only becoming financially literate in general before you invest, but also doing research into various industries, businesses, and financial instruments.
Even experienced investors can and do benefit from working with a financial adviser. If you’d like to learn about how our advisers can help you develop your own financial skills, manage your investments, or otherwise help you reach your financial goals, reach out to us today.