How to Hedge Your Investments

Hedging is not a word you might hear often when investing. And although it might sound fancy, the concept of hedging is much simpler than you might think – it’s simply a way for investors to protect their investments.

Hedging is …

Hedging can be considered as an insurance policy. Investors can opt to hedge when they want to prevent their portfolio from being hurt in the event of any particular scenario occurring. This is similar to an instance of you purchasing a property and then hedging it against any unforeseen fire-related calamities by buying fire insurance.

Here’s an example using a real-life situation. Let’s imagine you are invested in Golden Agri-Resources (SGX: E5H), a company that might be highly affected by the price of the crude palm oil (CPO) given its status as one of the largest palm oil producers in the world.

Let’s further imagine that you had bought into Golden Agri-Resources because of certain operational improvements you hope to see in the company instead of just hoping for a rise in CPO prices. In such an instance, you might want to diminish the risk of your investment being negatively affected by falling CPO prices by choosing to hedge this risk. You could do so by shorting some CPO future contracts (when you short a futures contract, you can profit when prices fall) while still holding on to your investment in Golden Agri-Resources.

Natural hedging

So, the above discussion might still be complex for some. But unbeknownst to many, when you invest, you might have inadvertently come across a “natural hedge” situation.

This is a situation where you have created a hedge for yourself without the use of complex financial derivative instruments. For instance, let’s imagine that you had chosen to invest into the Indonesian stock market directly through Indonesian-listed companies. With such investments, it’s natural to be worried about the issue of currency risks.

However, as economic theory states: When the currency of a country depreciates, it might be beneficial to exporters within the country as they are able to experience cost savings in their local production activities but yet earn more by exporting products in a foreign currency that has appreciated. Thus, if you had invested in an Indonesian-listed product-exporter with operations there, you’d have created a natural hedge situation for yourself in terms of hedging the risk of the Indonesian rupiah declining in value.

Foolish Summary

Almost all hedging activity comes at a cost. Therefore, it is important for us as investors to weigh the pros and cons before making a decision to hedge or not. In any case, do bear in mind that sometimes, the cost to hedge is so dear that it might actually be wiser to just accept the risks as they are.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.