With the current global economic growth slowdown, many are concentrating on wealth stability and protection. How do we hedge in our investments from external shocks? 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, but it reduces the financial losses from those events. Life is full of risks like security, weather, health, travel and of course, investment risks. 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 at this time, we should deploy effective hedging strategies.
Hedging can be done simply or through 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 broadly divided into equity risks for equities and interest rate risks for 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 2%, but interest rates go up to 4% 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 banking 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 the exchange rate as the naira has experienced in recent months. 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 – many faced that situation when rates crashed in 2020. 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, again, we are facing this as we speak.
How then do we manage these seemingly inescapable risks? The most common hedging strategy is portfolio diversification as 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 our income. Now equities are doing well, but money market has crashed. We hedge against liquidity risks first by ensuring that our spending budgets accurately reflect of our monthly expenses and leave room for unforeseen events in these COVID times. Also, our portfolio is not filled with hard to monetise assets like real estate or retirement savings but include more liquid assets that can be easily converted to cash in times of urgent need. To hedge against inflation, we need assets that deliver returns and capital appreciation that are higher than the inflation rate, like real estate. Another is an inflation-indexed mutual fund; professionally managed fund that only invests in assets that deliver returns higher than inflation.
Lastly, we should physically safeguard tangible assets like jewelry, houses, artwork, etc, from damage, theft, or loss. And we should ensure they are adequately insured.
Let us keep up to date with the peculiar risks our various investments face and ensure we effectively protect our wealth against them.
Happy investing.
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