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When it comes to investing, assessing how to manage risk is among the most fundamental decisions an investor must take. Two strategies an investor may take are hedging and speculation.
Knowing the difference and knowing when to hedge and when to speculate could make a huge difference in an investor’s portfolio – hedge too much and you could miss out on potentially profitable opportunities, while overspeculation could lead to massive losses.
Hedging is a financial investment strategy whereby an investor can offset potential losses in investments by taking another position in another asset or the opposite position in the same asset.
The secondary position acts as an insurance against potential price drops in the initial asset. The ultimate purpose of hedging is to reduce risk by protecting against market volatility and preserve capital rather than generating higher returns.
Read more about: Traditional Hedging vs Halal Hedging Strategies
One of the most common ways used to hedge, diversification simply involves investing in multiple assets classes.
A typically well-diversified portfolio would see a variety of assets such as stocks, bonds, currency, and real estate. If the price of one drops, potential growth in another asset class would offset it.
Despite their reputation as being a speculative asset in recent years (thanks to the global financial crisis), derivatives were ironically initially created as a hedge against price fluctuations in assets that experience market volatility such as commodities.
Futures contracts for example, protect a farmer or seller of a commodity by locking in a predetermined price today for a future delivery date.
Derivatives can also be used in assets such as currencies and stocks through forwards, puts and options. A trader in one country, for example, can use forward options to set a predetermined exchange rate to protect against currency fluctuations.
Read more about: Are Financial Derivatives Halal?
This strategy involves making a bet on the same asset (or asset class) an investor is in potentially falling in value.
The most common ways to do this is through derivatives or going short or long. Using derivatives, an investor that holds an outsized position in a particular share can buy put options that pay out if that stock falls.
That investor can also hold a short position (betting that the price would fall) in the same stock they’re invested in.
Speculation is an investment strategy that aims to maximize profit on a particular asset by placing a large bet on it, characterized by a very high risk tolerance. In many ways it is the exact opposite of hedging, as it relies on maximum risk to achieve maximum rewards by taking outsized positions in assets.
Speculation can take numerous forms – too numerous to count. However, there are characteristics that form a line (albeit a very thin one) between speculation and gambling:
- Strong market acumen: Speculation should really be left to those who understand the market well enough to be confident in taking an outsized position. It involves experience, technical analysis, and an understanding of macro and micro trends of the market.
- Leverage: in order to maximize returns on a position, speculative traders usually take highly leveraged positions by borrowing. The flipside is that if the trade goes wrong, losses are multiplied as well.
- Derivatives: Derivatives can also be used to double down on a bet. For example, if a trader expects a commodity to rise, they can purchase the commodity and a tradeable futures contract to maximize returns on that commodity.
Ultimately, the answer to that question depends on the investor themselves – what is their goal, what is their level of risk tolerance, and what is the preferred time horizon on a return on investment.
Hedging works best when
- The investor has a low risk appetite
- When the investor wants to protect against market volatility
- The investor wants to preserve and save wealth more than maximize growth
- The investor does not mind a longer term, yet stable, time horizon
- The investor prefers to have assets managed by an institution over the long term.
Speculation works best when
- The investor has a high risk appetite
- The ultimate goal of the investor is to maximize profits
- The investor has a short time horizon on returns
- The investor knows the market well and has the technical ability to make educated predictions
- The investor can actively manage their portfolio to better adapt to short-term movements (hourly, daily, weekly) in the market
The investor has sufficient capital to absorb losses – which are likely to happen.
Read more about: Time-Weighted vs. Money-Weighted Investment Returns
Disclamer:
This post is for educational purposes only, and does not constitute investment advice or a solicitation to take any financial action. It should not be relied upon when making investment or financing decisions.
