Hedging and wealth protection

A hedge is a form of fencing, protecting against incursions and intrusions. In investment portfolio management, hedging is an essential risks management tool. Some may simplistically call it insurance, because it acts like insurance and cushions the potential losses one may incur if adverse events occur. Like insurance, hedging does not prevent negative events, it only reduces the financial impact of those events. Like is full of risks. We have security risks, weather risks, health risks, travel risks and much more, so investment cannot be left out. Each asset class and different assets within one class, has its own peculiar growth cycle, income pattern and life cycle; they also have their own unique risks like market risk, concentration risk, liquidity risk, currency risk, reinvestment risk and inflation risks. In order to manage our investment portfolio optimally and prevent wealth erosion by these potential risks we must employ effective hedging strategies.

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Like most things in life, hedging can be done simply or by using elaborate hedging strategies like financial derivatives.  Derivatives are speculative financial instruments that attempt to forecast the future value of an asset. The word derivative is from the root word derive; derivatives derive their own value from the underlying assets whose future value they are trying to forecast. We would leave financial derivatives to the professional portfolio managers and discuss simpler, common sense ways to hedge our investments. However, if we have a substantial part of our wealth in mutual funds, our due diligence should include a review of the hedging strategies of the fund manager.

Before we look at the hedging strategies, let us review the risks our investments face. Market risks can be divided into equity risks for investments in shares and interest rate risks for investments in money market. Equity risk is the risk of a drop in the market price of shares. Interest rate risk is the risk that interest rates go up, but you have been tied down to a lower interest rate, e.g. you book a 180-day fixed deposit in January at 9%, but interest rates go up to 11% in February, you are stuck with lower interest rate for the next 5 months. Concentration risk occurs when all your investment is in one asset class or worse still, within one section of one asset class; like the man who not only has all his investments in shares but has further restricted himself only to petroleum sector shares. Liquidity risk is associated with assets that are not easy to sell or assets whose pricing is subjective. The owner may not get a fair price if she attempts to sell it quickly. Liquidity risks also emerge when we put too much money into investments and not enough for daily expenses. Currency risks are associated with fluctuation in exchange rate. In the money market, reinvestment risks are regarded as the opposite of interest rate risk; they occur when interest rates go down so that when your current fixed deposit matures, you cannot find another fixed deposit instrument that would give you the high returns you got from the matured one. Inflation risk is the risk that the purchasing power of your portfolio is eroded by inflation because growth generated on your investments is lower than the attrition from inflation.

The simplest and most common hedging strategy is portfolio diversification. It hedges against many risks. Firstly, concentration risk, so that if one asset or asset class is performing poorly, the good performance of other assets would balance it out and stabilize your income. We must however avoid overdiversification as this too can erode return on investment.We can hedge against liquidity risks first by ensuring that our spending budgets accurately reflect of our monthly expenses. Then we ensure that our portfolio is not filled with hard-to-sell assets like real estate or retirement savings account butinclude enough liquid assets like fixed deposit or treasury bills that can be converted to cash within 48 hours. To hedge against inflation, we need assets that deliver return and capital appreciation that are higher than the inflation rate. The most effective asset for this is real estate. Another is an inflation-indexed mutual fund; that is managed with consciousness of watching the inflation rate and buying only assets that deliver returns higher than it.

To conclude – we must be aware of the peculiar risks our various investments face and make sure we intentionally and effectively protect our wealth against them.