What Is Hedging
and How Can It Benefit My Portfolio?
The best way to understand hedging is to think of insurance: When people decide to insure, they are hedging themselves against a negative event. This doesn’t prevent a negative event from happening, but if it does happen and you’re properly hedged, the impact of the event is reduced. So, hedging occurs almost everywhere, and we see it every day. For example, if you buy an umbrella, it won’t prevent a downpour, but it will help keep you dry.
Portfolio managers, individual investors and corporations use hedging techniques to reduce their exposure to various risks. In financial markets, however, hedging becomes more complicated than simply paying an insurance company a fee every year. Hedging against investment risk means strategically using instruments in the market to offset the risk of adverse price movements in the securities you own. In other words, we have to hedge one investment by making another.