The ABCs of hedging

December 6th, 2006

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One of the claptraps that we get to see nowadays is ?Hedge Funds.? According to the Encarta dictionary, the word ?hedge? is defined as: ?a means of protection against something, especially a means of guarding against financial loss.? A ?hedge fund? was originally meant for managed funds that employ hedging to protect against any market downturn and perhaps even profiting from it. Today, there are many funds that call themselves ?hedge funds? even though in reality, they do not hedge at all. Those fund managers are more akin to gamblers betting on anything that they can get their hands on, often using huge amount of borrowed money and derivatives to magnify their punts. In addition, unlike the conventional gamblers in the casino, those gamblers are usually absolved from personal losses if they lose their bets. Instead, it is often those poor investors who entrusted their money to those scoundrels who have to pay the price. Worse still, if those gamblers won their bet, they will often be the first to carve out a slice of their winnings. Thus, if you should decide to entrust your wealth to a hedge fund, please make sure the fund manager is not a gambler in disguise and that the fund does indeed hedge. There are too many quacks, swindlers and cheats in the financial industry waiting to devour your money.

Now, as a private investor, how do you hedge your portfolio? In other words, how do you reduce the risk of potentially significant losses in your portfolio?

The most well-known and basic technique is diversification, which is spreading out your investments across different stocks, industry, asset classes and so on. Unfortunately, this technique has major limitations. Firstly, though diversification reduces your risk, it also reduces your chances of making big gains. It is possible to over-diversify, which will result in mediocre returns over the long term. Secondly, diversification will not protect you against major economic catastrophe when deflationary forces wipe out the value of almost every class of investment. Thus, for investors after atypical excellence, diversification is not the most favoured method of hedging because they would rather reduce risks by increasing and improving their skills, knowledge and understanding then by scattering their eggs over many baskets. The best investors would rather concentrate their investments on the ones that they understand intimately than to spread out their investments to make up for lack of understanding. In other words, diversification is a very blunt tool for hedging.

What is the more precise strategy for hedging? For long-term value investors, there is this ?war-gaming? approach. Military planners often go through war games where they work out the outcome of all the possible scenarios and develop strategies to specifically counter each of the unfavourable outcomes. The same can be applied to investing. This risk management approach will determine how you structure your portfolio. Given each of the economic what-if scenarios, what are your plans to ensure that your portfolio will survive and perhaps even thrive? For example, what are your plans for your investments if oil prices sky rocket? What happens if the US dollar collapses? What if the global economic imbalances unwind disorderly? For you to be able to evaluate the ?war-gaming? scenarios, you would need to understand both global and local economic conditions. That is why in this publication, we often delve into economics, which some novice investors mistakenly believe is irrelevant and is the ?job? of the government.

Then there are the more tactical approaches for hedging, which is more relevant for short-term traders but nonetheless can be adapted for long-term investors as well. The most basic of these is the stop-loss. It is a tool mainly used by trader to pre-define the price which they will exit their position regardless of what their emotions tell them in the heat of the battle. Stop-loss does not prevent you from making a loss?they let you pre-define your potential loss before you enter the trade. For those more advanced traders, there are more powerful tools for hedging using derivatives. For example, delta-neutral option strategies allow you to potentially profit from all kinds of short-term market situations and limit your losses to pre-defined levels should you turn out to be wrong.

There are a lot more to hedging and risk management than we can say in this article. We hope this will be a good starting point for you.

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