Protecting your portfolio is as important as trying to make gain from your investments. We hedge ourselves against risks all the time, insuring ourselves against possible negative events by buying insurance.
Since we are already hedging ourselves against these possible negative events in life, we do not see a reason why we should not be doing so for our investment portfolio. If you are still confused, hedging your investments is similar to “buying of insurance” for your investment decisions. But of course, this safety strategy also comes at a price, as hedging limits potential profits.
Below we discuss some of the investment instruments we can look for as a form of insurance for our investments.
Purchasing defensive stocks
Assuming you have a portfolio heavily vested in companies related to industries such as the airlines business or companies that manufactures autos. In times of an economy boom, these companies tend to do well with the increase in demand for cars and travel. However, their share prices will take a tumble in the opposite direction when the economy is in a slump.
One way to reduce your losses in such circumstances will be to purchase defensive stocks. These stocks might be from industries that produces consumers necessities, such as food, utility and healthcare such that in times of a economy downturn, these stocks tend to hold their value or might even gain in value.
An option is a financial derivative that represents a contract sold by one party (option writer) to another party (option holder). The contract offers the buyer the right, but not the obligation, to buy (call) or sell (put) a security or other financial asset at an agreed-upon price (the strike price) during a certain period of time or on a specific date (exercise date).
An example will be investors having possible doubts about the volatility of the price of a certain stock he just purchases during the short-run. The investor can choose to purchase the put options for the stock such that the money made from the put option offsets a drop in the value of the share.
Adverse investment instruments
On top of defensive stocks, one may wish to invest in another stock that has a negative correlation with the ones he purchases. The idea is that with a negative correlation, the drop in one stock should be offset by the gains in another stock. Buying stocks with negative correlation is a legitimate strategy employed by professional fund managers in order to reduce risk through diversification.
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