Various uncertainties are possible when you keep an investment portfolio, including not knowing if and when a market crash will occur. These can cause a range of risks, so you need to ensure you can reduce the possibility of these risks and their impact.
You can hedge your investment portfolio in several ways, including buying gold. For example, instead of having all your investment in fiat currency, you can convert some into gold by buying gold. You can use gold as inflation hedge as it doesn’t depreciate due to inflation.
What Is Investment Portfolio Hedging?
Hedging is a way of insuring yourself against a negative impact on your financial status. Therefore, portfolio hedging insures your investment portfolio against risks such as volatility.
It’s important to note that hedging doesn’t prevent risks from taking place. Instead, it reduces the damaging impact of the risks.
How Does Portfolio Hedging Work?
You can choose to use hedging to protect individual security or multiple ones. Individual security is protected if it carries risk. However, hedging is mainly done at the portfolio level because most people prefer protecting their whole stock from market risks.
There are various ways to ensure the effectiveness of investment portfolio hedging. Continue reading to learn more about this.
As already mentioned, you can hedge your investment portfolio by buying gold.
During geological risks, the demand for gold increases. This results in a spike in gold prices.
Hence, purchase gold, preferably non-physical gold, before its price hikes. By doing so, you’ll save yourself by reducing the impact of volatility.
In addition, you can make profits by buying gold at a lower price and selling it at a higher price later on.
Moreover, you can use the liquidity gained to get other equities at a lower price.
Diversify In Various Investments
Putting everything in one investment increases the risk of losing your investment at once. Thus, it’s best to invest in various sectors.
Having portfolio diversification helps by distributing financial risks across various fields. This distribution of financial risks helps in many ways, such as:
- Reduces the effect of market volatility
- Safeguards your capital
- Saves time spent on portfolio monitoring
- Promotes peace of mind (because not everything is about serious business)
- Lets you enjoy compound interests
- Helps in achieving your long-term investment plans and goals
Aside from investing in gold, you can also choose to invest in various unrelated fields such as real estate.
Real estate is considered a good investment because land value tends to appreciate over time, so the chances of volatility in this field are minimal.
Stick To Cash
One of the ways you can hedge your investment portfolio is by sticking to cash.
Sticking to cash, in this case, doesn’t mean holding all your cash but rather keeping just enough to take you through a given period and using the remaining in investments.
You can hold your cash in various accounts, such as savings or money market accounts.
Holding cash is an effective way of hedging as it offers the following benefits:
- Having cash allows you to venture into other investment options that could be better than your current investment.
- Holding cash prevents you from needing to access your money in emergency cases. Instead, you can cater to your short-term needs using the cash you’re holding.
- Unlike other hedges, your cash won’t lose value if your other hedges fail to work.
Additionally, holding cash reduces volatility and downside risks based on these benefits.
Short-Sell Index Futures
One of the simplest ways of hedging risks is by short-selling indices. This involves selling future indices against your portfolio.
In doing this, you might incur a loss if the level of indices increases. However, this is better than going through a downside risk. This shouldn’t be an issue because your goal is to hedge your portfolio. Besides, the level of an index going up might increase the value of your portfolio.
Furthermore, the most used index is the S&P 500, which offers the following benefits:
- Offers favorable taxation, where 60% of your gains are taxed under the category of lower long-term capital gains. The remaining 40% is taxed under the regular income category.
- They’re cash-settled, which makes managing expiration easy.
- They have a 100 multiplier that allows you to counterpoise a reduction in a portfolio at a low upfront cost.
Yet there are drawbacks associated with short-selling indices. For example, you should note that short-selling is costly and requires you to cover dividends.
Buy Put Index Options
Put indices differ from future indices because they advocate for a right to sell. Meanwhile, future indices advocate for the obligation to sell.
When you buy a put option, you get the right to sell it if you want to. However, you have to pay for this privilege. This price is known as option premium.
Put indices work the same as future indices because you can sell your indices before their expiration to avoid volatility. You might also make losses in the process.
Other ways of effective hedging that you can use include:
- Fence – a combination of a put spread and collar
- Put spread – combines long and short put indices
- Collar – involves purchasing a put option and selling a call option in exchange
- Purchasing securities using inverse returns
Choosing The Right Hedge For Your Portfolio
You can use the following steps to choose the right hedge for your investment portfolio:
- The first would be to consider the advantages and disadvantages of the available hedging options.
- Next, consider if you want to hedge your whole portfolio or only a part of it. You’ll need a smaller hedge if it’s part of it.
- Find market indices that match your investment portfolio.
- Decide how much of your upside you’d be willing to lose.
- Lastly, consider the prices of various hedging strategies and settle on one that suits you best.
Summing It Up
An investment portfolio faces its share of risks, like if there’ll be a market crash. The impact of a market crash can be adverse, so you must develop ways you can use to minimize this impact.
This is what is known as hedging your investment portfolio.
You can hedge your investment portfolio in several ways, including diversifying your investments and the rest discussed in this article.
Consider implementing any or all of them if you’re thinking of hedging soon.