“Successful investing is about managing risk, not avoiding it.” - Benjamin Graham
All investments carry an intrinsic risk. Even companies that are considered safe for decades or more can suddenly crash in value, like banks in the 2008 financial crisis. Wise investors understand the inherent risks in different types of investments and mitigate them, balancing risk management with the necessity of realizing their financial ambitions. Natural hedging is a way of managing risk when structuring your investment portfolio.
In this article, you’ll learn about:
• What is natural hedging?
• The advantages of natural hedging
• The disadvantages of natural hedging
• Examples of natural hedging in portfolios
• Other types of hedging
• Natural vs financial hedging
• Can you use natural and financial hedging?
What is natural hedging?
Natural hedging is an investment strategy for lowering risk by investing in different assets that share a negative correlation, meaning they are likely to have an inverse performance. So if one investment performs badly, the other is likely to perform well, reducing the losses on the first. For example, typically equities perform well when bonds do poorly, while stocks suffer when bonds do well. It is a simple strategy that doesn’t require sophisticated financial instruments such as futures, swaps or derivatives.
As an example, expats could hold assets in different currencies to mitigate the risk of the two currencies’ values fluctuating.
Natural hedging as a risk management strategy doesn’t provide 100% risk elimination, but it will help reduce risk when structuring your portfolio.
Advantages of natural hedging
The main advantage of natural hedging is minimizing losses if a particular investment unexpectedly drops in value.
All investments fluctuate in value all the time, due to market sentiment, government policies, company management decisions, and currency movements, among other factors. Natural hedging allows investors to reduce their exposure to losses caused by these factors beyond their control.
It is also a cost effective risk-reduction strategy, as, once set up, portfolios don’t need constant monitoring and adjusting.
Disadvantages of natural hedging
On the flip-side, natural hedging can inhibit portfolio growth, as conversely when one investment experiences gains, it’s probable that the investments bought as a natural hedge will experience a loss.
The key to using natural hedging successfully is to seek good advice as to the exact investments that you pick as part of your natural hedging strategy, to ensure that you still achieve your growth goals.
Examples of natural hedging in portfolios
Finding assets that exhibit a negative correlation with each other requires experience, research, and time-consuming technical analysis.
Natural hedges can involve matching assets in different currencies, as already mentioned.
Another example is if you hold stocks and government bonds, which are a traditional natural hedge for stock losses because they are inversely related; if one appreciates, the other typically depreciates. Profitable stocks and under-performing bonds, or vice versa, are often used to offset each other's losses.
Another often-used hedge is gold against stocks, as when stock markets suffer losses, investors often turn to gold as a safe haven, which causes the price of gold to rise due to increased demand.
Finally, some investors who hold riskier investments also choose to keep a proportion of their portfolio in cash, so that in the event of a market fall they are still in a position to invest and so benefit from a subsequent upturn.
Other types of hedging
Pairs trading
Pairs trading involves taking both long and short positions against two highly interrelated assets, most often two stocks in the same sector.
Pairs trading is a strategy often used by hedge funds - in the year 2000, out of $137 billion invested in hedge funds in the US, $119 billion was invested in pairs trades.
One major hurdle in pairs trading is that it can be hard to identify assets with the required correlation, however your expat financial advisor should be able to help if you’re interested in exploring pairs trading in your portfolio.
Financial hedging
Financial hedging involves trading in derivatives like futures and options to offset the price movement of a closely related transaction.
So if you hold a stock in Apple for example, you could reduce the risk of a share price fall by also taking a position that the stock price will fall. That way, you profit both if the price rises or if it falls, and limit your exposure to the risk of a particular asset decreasing in value.
It's similar to buying an insurance policy in a sense, as it covers you against the potential risks of financial losses.
Financial hedging vs natural hedging
The major disadvantage of financial hedging is that it is more expensive than natural hedging due to the costs of purchasing the positions against an asset price falling. This may mean trading futures, options, and inter-currency interest rate swaps. In general, natural hedging is preferable, as it’s simpler and more cost-effective.
Can you use both financial and natural hedging?
It’s definitely possible to utilize both financial and natural hedging to reduce the risk of losses when you structure your portfolio. Whereas natural hedging can (and normally should) be used to reduce risks of losses in an asset class, financial hedging could be a good option if you have a high exposure to a single asset, or if you expect volatility with a particular asset.
If you have any questions, don't hesitate to contact us.
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