Wealth CAP has developed dynamic bucketing portfolios (DBPs) in order to diversify your assets while maintaining a great balance of liquidity, security, and growth. Diversification, which is the spreading of your assets into different investment vehicles in order to minimize risk, is vital to the success of our dynamic bucketing portfolios (DBPs). But what about hedging? Can’t hedging be used to mitigate risk as well? Wealth CAP, an online investment company, will explore hedging and how it’s different in this blog post. Contact us today for more information!
WHAT IS HEDGING?
In its pure definition, hedging is an investment you take out to balance the risks of another investment. Hedging is something most of us do on a fairly regular basis, you just don’t think about it. For example, when you buy milk so you “don’t run out”, or you buy life insurance to support your family in case you die, you are hedging. Hedging is known for being complicated and sometimes the investments used to hedge (such as hedge funds) can be complicated; however, just keep in mind that you are attempting to offset risk, much like diversification, with hedging.
To understand how hedging works in the financial industry, let’s take a look at an example. Let’s say you want to invest in a new company called WalkMyDog that makes an automatic dog walker. This robot will walk your dog for you any time of day and night, will pick up after your dog, and will even teach your dog how to walk on a leash properly. This robot is ten times better than the competitor’s robot at DogsRule. The competitor’s robot only walks your dog in a straight line up and down the street. It has no obedience training, and it doesn’t pick up after your dog. Thus, WalkMyDog’s stock should skyrocket once this robot hits the market.
However, the markets being inherently unpredictable, could not like WalkMyDog’s robot and the stock could not rise. The risk of investing is called industry risk. In order to reduce industry risk (and hence major losses on your part should WalkMyDog’s robot tank), you decide to hedge. You go long on the stock of WalkMyDog (expecting it to go up) and go short on the stock of DogsRule (expecting it to drop so you sell it with the intentions of buying it again in the future at a lower price). If the industry as a whole increases, you’ll make money on WalkMyDog but lose some on DogsRule, but overall you should make a tidy profit. However, if the industry goes down, you’ll make money on DogsRule instead and lose money on WalkMyDog. Going long and pairing it with a going short in the same industry is known as a pairs trade. Hedging is common in sectors that have risk.
Hedging has become more popular in recent years. Hedging is used a lot in options trading, which can get complicated very quickly. In essence, every investment has some form of a hedge. It’s the “in case” decisions you make sometimes on a daily basis. Hedging protects an investor from various types of risk and makes the market run more efficiently.
WHAT’S A HEDGE FUND?
Hedging is often confused with hedge funds, and in reality, they don’t have much to do with one another. A hedge fund is a fund first off that is classified as an alternative investment. It’s a fund of a group of investors who pool their money for investments in securities. Hedge funds are not regulated by the SEC (Securities and Exchange Commission). This gives them the freedom to invest in alternative investments and use more risky investment techniques and vehicles, such as shorting stocks, taking a long position on a stock, investing in derivatives, which are contracts to buy or sell securities at a specified price, and use leveraging, which is investing with borrowed money. All of these techniques require skill and experience, and due to the increased risk, is something most financial planners shy away from for their clients.
Another major differentiator between hedge funds and other investment funds managed by investment professionals is the compensation model. Hedge fund managers are paid a percentage of the profits they earn plus a small management fee. This commission structure is comforting to some investors because if the hedge fund performs badly, the hedge fund manager is getting a low paycheck and is thus incentivized to perform better; whereas, a mutual fund pays their investment managers fees regardless of performance. On the flip side, hedge fund managers may be more likely to make aggressive investments in order to get paid more; however, most hedge fund managers have some of their own money invested in their hedge fund, decreasing this likelihood considerably.
Hedge funds have had a checkered past ever since their invention in 1949. Many people think of huge returns when they think of hedge funds (which is possible, giving the risky investments they make), or they think of Bernie Madoff who pilfered people’s retirement savings. Hedge funds are required to be accredited and earn a minimum annual income, with a minimum of $1 million net worth, and the hedge fund managers must have years of experience.
THE BENEFIT OF HEDGING
Hedging itself, whether in your portfolio, your business, or your daily life, is about decreasing or transferring risk. Hedging is a valid investment strategy that can help protect your portfolio, home, and business from uncertainty and volatility in the markets and the economy.
THE DOWNSIDE OF HEDGING
As with any risk versus reward tradeoff, hedging results in lower returns than if you “bet the farm” on a volatile investment, but it also lowers the risk of losing everything and leaving you broke. Since most people are risk averse, hedging is a great way to make a bit of extra return with the same amount of equivalent risk.
Wealth CAP believes in the power of diversification to earn the most return in your retirement strategy. Using our dynamic bucketing portfolios (DBPs), which spread out your risk according to your comfort level, Wealth CAP is able to put together an individual retirement income plan that will preserve your income throughout retirement. We pride ourselves on always being available to answer your questions. Furthermore, we offer our Individual Financial Wellness Education program in order to enhance your learning and your knowledge about investments. We balance your portfolio, using safe investments, market investments, and alternative investments, to create security and liquidity while maximizing returns. We are not hedge fund managers and do not use any advanced investment tools beyond investing in alternative investments such as real estate for diversification purposes. To schedule your free consultation, contact us today!