"Hedge your bets," say the wise.
In the beginning, "hedge funds" actually hedged, meaning that they would make money in both rising or falling markets. Nowadays, the "hedge" in "hedge fund" has lost all meaning. Hedge funds simply invest in risky investments and/or use leverage (borrowed money). Most hedge funds these days do not hedge at all.
So what does it mean, exactly? What is hedging?
Hedging, in simple terms, is a method for taking precautions against financial risk. The goal of hedging is not to make money; rather, it is to prevent losing money.
As an example, if you are worried about a stock market crash, you can buy put options against the stock market, which gain in value if the market drops. Of course, if the stock market goes up, the value of your put options goes down – and the outcome is neutral. If you are a baker and are worried about the rising cost of grain, you can buy wheat futures that gain in value if the price of grain increases. If the price of grain declines, you will lose money on your wheat futures, but also pay less for the wheat you need – again, a neutral outcome.
The financially sophisticated investor has almost unlimited choices for hedging. But, this article is not about these sophisticated hedging choices. It is about simple hedging for the layman.
Hedge #1, Insurance
Say, for example, that you are a married father of two. If you were to pass away, your spouse would be left with the mortgage payments, the costs of raising two children, etc. Therefore, the wise person buys life insurance. If you pass away, your income to the family is gone forever; however, the life insurance pays off the mortgage, with hopefully enough money left over to see the children through college. Thus, life insurance is your “hedge” against possible financial ruin caused by your premature death. Virtually everyone should have life insurance, disability insurance, home insurance, and home content insurance (the building and its contents are usually insured separately). The goal of insurance is not to have so much as to guard against any possible occurrence – it is to buy just enough to prevent extreme financial hardship.
Hedge #2, Gas and Oil
If you drive, consider buying stocks of a large oil company, or an energy mutual fund. As the price of oil (and gasoline) goes up, you can be compensated by an increase in the value of your oil company stock, and also an increase in the amount of dividends it pays you. If the price of oil goes down, your oil stock may decline in value, but so will the price you pay at the pump – this is classic hedging.
Hedge #3, Real Estate (for current non-owners)
If you rent, consider buying a real estate investment trust (REIT), a form of stock market real estate investment. If real estate values increase (along with your rent), the income provided by the REIT will also increase. If real estate values decline, your rent will likely not decline (unless you change buildings), but it won’t go up, either – a 3/4 hedge.
Hedge #4, Household Energy
Almost everyone pays for electricity and heating supplied by a utility company. Utility companies are not only some of the safest investments around, but they also pay regular dividends. The more money they make, the larger the dividends. Utilities can be bought through utility ETFs or utility mutual funds.
The first hedge (insurance) can save you from ruin and protect your family. The final three are long-term inflation killers. Together, and for a minimal outlay of cash, they protect you from both unforeseen circumstances and unexpected costs.
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"(Gold) gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head."
Warren Buffett
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Do not buy stocks, or take this or any other financial advice without doing your own analysis; including, but not limited to: reviewing business models, financial statements, management style and philosophy, recent developments, market macroeconomic analysis, and chart analysis. If you do not know how to do these things, you shouldn't be buying stocks in the first place. Seek the advice of professionals, as appropriate.
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