Your personal or business assets need not be at financial risk. Knowledge of a few basic principles can enable you to plan their protection by hedging. Hedging is the establishment of a financial position which will grow in value – as the value of other assets shrinks.
Gold for example, generally grows in value as the purchasing power of the dollar shrinks. You can solve this shrinking dollar problem – known as inflation – by purchasing gold or silver with dollars. Then, as inflation erodes the value of the dollar, the price of your metal increases, offsetting the loss. Corporations and wealthy individuals hedge their financial risk in this manner and in many cases hedging is the only reason they’re still in business – or wealthy.
Hedging can be used to minimize a variety of personal and business financial risks. For example, what would be the effect on your commute or your business if the price of gasoline were to double or triple? Hedging could offset the some or all of the price increase. A delivery business able to fuel its trucks at $2.80 per gallon could thrive if the competition had to buy gasoline for $4.00 – or higher.
If you own stock or bonds in a retirement account, are you comfortable betting your retirement on what might happen on Wall Street? Whether your risk is business or personal, and whether it involves the purchasing power of the dollar or the cost of heating and cooling your home, hedging can provide a solution.
Hedging is not complicated financial wizardry.
First, Identify Your Risk
You have risk if you own dollars – or expect to receive dollars in the future. Will the dollars you receive as a pension payout have the purchasing power they have now? Similarly, if you own a bank Certificate of Deposit denominated in dollars, your purchasing power is being eaten alive by low interest rates and inflation. Stocks, bonds and mutual funds are all subject to substantial price risk.
Next, Identify a Hedge Vehicle
Gold and the dollar are interchangeable hedge vehicles because their value tends to move in opposite directions. Other hedge vehicles may be less obvious: a trucking company can hedge the possibility of higher diesel fuel costs by buying a futures contract in gasoline or even crude oil. All three are correlated – they move similarly in price. Assets can be hedged by purchase or sale of any correlated physical asset or futures contact.
Finally, Match the Risk
Hedges can never perfectly match your risk, but close is much better than nothing. For example, if you would like to protect your stock portfolio, it really isn’t necessary to guard against the price of all your stocks falling to zero. But you may wish to protect against a 20% downward price correction. Hedging can be tailored to either match your total risk or to eliminate only as much risk as you think you have. Similarly, a property owner who wishes to protect against the rising cost of heating with natural gas, has the option of capping the price at a fixed level or using a more flexible hedge to cover a range of future prices.
Hedging does require some number crunching in calculating and matching risk. And although there are costs associated with establishing a hedge, one that is properly designed will far outperform those costs. The exact form of a hedge and its timing should be planned with the assistance of an experienced risk manager.
Your assets are at risk and you can ignore that fact or address it. Hedging will not make you rich, but it can add stability to your finances by letting you maintain the value of what you already own.