Advantages & Disadvantages of Hedging in Finance

When making a large investment, financiers will often want to make a hedge investment. A hedge is a kind of insurance policy designed to protect the investor in the event that his large investment collapses. Stock values can go up and down from one week to the next, making investing risky. Like a physical hedge, this financial hedge provides protection, guarding the investor against significant losses. Yet, hedges are not always useful and, if not carefully purchased, can be a waste of money.

There are a number of different types of hedge that an investor can purchase. All perform the same basic task, which is to provide a counterposition that offsets the investor's main position. In the event that the main position fails to mature in the way that the investor planned, the counterposition will reduce his losses, either partially or in full, depending on the nature of the hedge. One hedge is completed through derivatives, which involves investing with strings attached. Someone may purchase 100 stocks at $10 with one $5 stock that has a put option of $8 expiring in one year. This allows the investor to sell all 100 shares for $8 within that year. Diversification is a popular type of hedging, involving someone keeping a portfolio filled with a wide range of stocks to avoid losing money on a particular type if that industry tanks.

The main advantage of the hedge is that it lowers the risk of an investment significantly. If an investor makes an investment in which variables are out of his control -- as is the case in nearly any investment -- then he stands to lose money if things do not go as he planned. A hedge can help him offset these losses and thus reduce any unwanted risk.

The main disadvantage of a hedge is that, in reducing risk, the hedge is also cutting into the investor's potential reward. Hedges are not free, but must be purchased from another party. Like an insurance policy, a hedge costs money. And, if the main position produces profits as planned, then the hedge will have been an unnecessary expenditure. Some investors would question the benefit of second-guessing the original investment in this way.

The relative advantages and disadvantages of a hedge will depend greatly on the situation in which the hedge is applied, as well as the hedge's cost. In some situations, a hedge will be absolutely necessary to make sure that an investor will remain financially solvent, regardless of what happens. In other cases, it merely signals an overcautious investor cutting into his own position.