Hedging: It is not always smart to hedge.

Hedging

Market or systematic risk - the risk that the overall stock market could decline - cannot be reduced through diversification but can be limited by hedging.

An investor's choice among many possible hedging strategies depends on the nature of his or her underlying holdings.

• A diversified portfolio of large capitalization stocks, for example, could be effectively hedged through the sale of an appropriate quantity of Standard & Poor's 500 index futures.  This strategy would effectively eliminate both profits and losses due to broad-based stock market fluctuations.  If a portfolio were hedged through the sale of index futures, investment success would thereafter depend on the performance of one's holdings compared with the market as a whole.
• A portfolio of interest-rate-sensitive stocks could be hedged by selling interest rate futures or purchasing or selling appropriate interest rate options.  
• A gold-mining stock portfolio could be hedged against fluctuations in the price of gold by selling gold futures.
• A portfolio of import- or export-sensitive stocks could be partially hedged through appropriate transactions in the foreign exchange markets.  

It is not always smart to hedge.

• When the available return is sufficient, for example, investors should be willing to incur risk and remain unhedged.  
• Hedges can be expensive to buy and time-consuming to maintain, and overpaying for a hedge is as poor an idea as overpaying for an investment.  
• When the cost is reasonable, however, a hedging strategy may allow investors to take advantage of an opportunity that otherwise would be excessively risky.  

In the best of all worlds, an investment that has valuable hedging properties may also be an attractive investment on its own merits.

Ways to Limit Opportunity Cost - Most Important is holding Part of your Portfolio in Cash

The most important determinant of whether investors will incur opportunity cost is whether or not part of their portfolios is held in cash.  

• Maintaining moderate cash balances or owning securities that periodically throw off appreciable cash is likely to reduce the number of foregone opportunities. 

Investors can manage portfolio cash flow (defined as the cash flowing into a portfolio minus outflows) by giving preference to some kinds of investments over others.  Portfolio cash flow is greater for securities of shorter duration (weighted average life) than those of longer duration.  Portfolio cash flow is also enhanced by investments with catalysts for the partial or complete realization of underlying value.

• Equity investments in ongoing businesses typically throw off only minimal cash through payment of dividends.  
• The securities of companies in bankruptcy and liquidation, by contrast, can return considerable liquidity to a portfolio within a few years of purchase.  
• Risk-arbitrage investments typically have very short lives, usually turning back into cash, liquid securities, or both in a matter of weeks or months.

An added attraction of investing in risk-arbitrage situations, bankruptcies, and liquidations is that not only is one's initial investment returned to cash, one's profits are as well.

Another way to limit opportunity cost is through hedging. 

• A hedge is an investment that is expected to move in a direction opposite that of another holding so as to cushion any price decline. 
• If the hedge becomes valuable, it can be sold, providing funds to take advantage of newly created opportunities .

Unlike return, risk is no more quantifiable at the end of an investment than it was at its beginning.

While security analysts attempt to determine with precision the risk and return of investments, events alone accomplish that.

Unlike return, however, risk is no more quantifiable at the end of an investment than it was at its beginning.

Risk simply cannot be described by a single number.  

Intuitively we understand that risk varies from investment to investment:  a government bond is not as risky as the stock of a high-technology company. But investments do not provide information about the risks the way food packages provide nutritional data.

Rather, risk is a perception in each investor's mind that results from analysis of the probability and amount of potential loss from an investment.

• If exploratory oil well proves to be a dry hole, it is called risky.  If a bond defaults or a stock plunges in price, they are called risky.  
• But if the well is a gusher, the bond matures on schedule, and the stock rallies strongly, can we say they weren't risky when the investment was made?  

Not at all.  The point is, in most cases no more is known about the risk of an investment after it is concluded than was known when it was made. 


There are only a few things investors can do to counteract risk:

• diversify adequately, 
• hedge when appropriate, and 
• invest with a margin of safety.  

It is precisely because we do not and cannot know all the risks of an investment that we strive to invest at a discount.  The bargain element helps to provide a cushion for when things go wrong.