How To Reduce Your Investment Risk: Hedging, Diversification & Insurance

When it comes to investing, we're generally giving up a sure thing to earn more. But we don't always have to concede and just accept the risk. There are steps we can do to minimize them. And in this article we'll quickly go through some of the ways we can help protect ourselves.




Insurance

What is it? This is something that probably everyone is familiar with. You pay premiums and, when something happens, the insurance company gives you money. It can be for a wide variety of things: sickness, your business burning down, your car getting hit or stolen, your house getting robbed, etc.

However, some people might measure the premiums with the benefit they get. It's important to remember that you're paying for is to have absolutely 0% chance that an unforeseen event will either wipe out your savings, bankrupt you, or take away your home.

How to do it: It's as simple as searching online or asking friends about insurance companies, getting quotes from them, and choosing which one you feel fits you the best.

Diversification 

What is it: Essentially it means not putting all your eggs in one basket. So if one investment is down, you can still earn from the other ones. More specifically, the investments should have very little correlation. One investment shouldn't be down for another to be up.

How to do it: To diversify, spread your money across different investment vehicles. If you like stocks, place part of your money in government bonds and/or time deposits & savings accounts.

Or if you have a lot of paper assets (mutual funds, UITFs) you could (if you decide it's right for you) invest in more physical assets: real estate, collector's items, or a business - provided you've done your homework and know how to do so already.

For those actively trading in the stock market, this means buying stocks of several different companies.

If you like bonds, try investing in both corporate and government bonds, instead of just one. Or if you prefer one over the other, invest in a variety of government bonds (or corporate bonds, whichever you choose).

It's worth saying though, that investing in just one type of investment vehicle (stocks, bonds) still doesn't make you diversified enough. But as long as you are informed and have a sound investment plan, you can take risks.

Hedging

What is it: This is one of the more complicated ways to avoid risk. And to be honest, most individual investors like us won't ever get to use it. However, since I don't hear or read about it as commonly as diversification and insurance, I decided to read up some more on it and share what I've learned.

Basically, you make a counter-bet - invest on something that will make a profit when your main investment posts a loss. The tough part is 1) finding a suitable counter-bet - something that will definitely make enough profit to offset losses in you primary investment and 2) finding the right ratio so that you are protected but can still profit.

But while this can potentially make an investment practically riskless (you won't lose money since the profit of one investment will always cover the loss of another investment), it also lessens the profit you can earn. This is strictly about protecting the value of your assets and not growing them.

How to do it: As mentioned before, individual investors won't get to use it as much.

However, if you earn in both pesos and foreign currency (or earn in one and spend in the other), Fitz has written an article on how you can use hedging to your advantage.

And if you have a business, you might already be doing this by buying a large supply of ingredients or raw materials at the current market price. Since the prices of goods can go up or down, you're basically locking up the current price to protect yourself against price increases that might limit your profit even further. The cost is the potential additional profit you are giving up should prices go down (and maybe the cost of having a large inventory as well).


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photo credit: dearoot via photopin cc

7 comments:

  1. Thanks for sharing what you've learned about hedging mas naintindihan ko na sya. I often see this term but I never really tried to understand it since I'm still new at investing.

    Napansin ko lang wala pa lang dates yung mga posts mo? It's not a big deal, I just noticed it while browsing some of your past articles.

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    1. Hi Diane!

      Yeah, nalito kasi ako sa hedging nung binasa ko kung ano siya, so ginawa ko na ding post nung naintindihan ko hehehe.

      Yeah, wala talaga silang dates. Pero siguro dapat lagyan ko na, yng iba kasi mejo time-sensitive like bank rates. Di ko nilagyan dati para mas mukhang "ever-green" hehe

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  2. Hehe cute yung ever-green idea yun nga lang tama ka pag me mga bank rates kelangan me date. Kaya siguro napansin ko kasi me isa akong tinitignan na post that made me think kelan mo ba ito na post? hehe

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    1. I think it was your post about "High-yield Savings Accounts in the Philippines" kasi yung comparison mo sa Equity funds me dates naman sa post mo.

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  3. Hey, I've been reading your blog and I find it entertaining and informative. I'm new to this blogspot thingy so I'm just sniffing around blogs that touch on financial matters. I've been reading Frugal Honey's blog too:)

    ReplyDelete