The word hedge has started to develope a poor reputation in recent years. A hedge fund is a company of corrupt overpaid Wall Street suits like Martin Shkreli… according to some people. People also use the term “Hedging my bet.” What I have found is that many people don’t understand the meaning of hedge, but they associate the word with gambling in one form or another. Hedge actually means to reduce risk or protect.
We are hedging in our daily life outside of investing. We protect against getting run over by looking both ways before we cross the street. We protect against poor health by exercising and eating well. We protect against unemployment by getting an education.
Hedging in Investing
The idea of hedging is very important in investing. We invest in stocks to protect against inflation. We invest in bonds to protect against stock market downturns. We invest in life insurance to protect against the possibility of dying and our loved ones losing our income. The way I run my portfolios and create my financial plans is starting with risk. What is the risk and how am I being compensated for it? Risk is why I have a portion of my bond positions that have a hedge against interest rates, because generally when interest rates go up bond prices go down. Risk is why I hedge against currency risk, because if the US dollar becomes more expensive international stock prices go down for us.
Hedging in Financial Planning
In financial planning, although the term is not used as much, hedging is at the core of what we are doing. We want to protect against the possibility of running out of money in retirement, having your estate passed down incorrectly, or of not being prepared for an emergency. Having a plan in place helps to hedge against these risks.