Quite simply, portfolio hedging describes a variety of techniques that can be used to reduce risk exposure in an investment portfolio.
The purpose of portfolio hedging is to limit risk and curtail potential losses, according to certified financial planner Geri E. Pell. It's something that every investor should know about, because it can help ensure them against a negative event, says Pell, who is CEO of Pell Wealth Partners, a private wealth advisory practice of Ameriprise Financial Services.
This safety strategy also comes at a price, since hedging also limits potential profits, Pell explains. So, hedging, for the most part, is a technique not by which you will make money but by which you can reduce potential loss.
Since hedging has a cost, investors need to weigh such costs against potential benefits—on a case-by-case basis. For most buy-and-hold investors, hedging is unnecessary, since short-term price swings in a portfolio won't matter.
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How does an investor hedge? It's complicated.
Hedging techniques generally involve the use of complicated financial instruments known as derivatives, the two most common of which are options and futures. With these products, an investor can develop a trading strategy where a loss in one investment is offset by a gain in a derivative.
The bottom line is that an understanding of hedging will help you to comprehend and analyze complicated financial investments. It's obvious that risk is an essential and precarious part of investing, Pell explains.
Having some basic knowledge of hedging strategies and learning about how hedging works will help advance your understanding of the market, which will in turn help you to become a better investor.