Hedging to improve investment outcomes is a key component of our philosophy. We typically discuss risk and return and how one impacts the other. In this article, however, the focus will be exclusively on risk and how it can be managed and even reduced, through effective hedging techniques.

What is a Hedge?

Simply put, a hedge is a form of protection, or defense, against losses. Much like how a homeowner’s insurance policy can protect the asset from the financial risk of flooding, the use of hedges can reduce potential risk to investment portfolios. When properly implemented, hedges allow investors to remain steadfast in their investment strategy during times of market volatility.

Loss Aversion and Investor Behavior

Loss aversion is a concept in behavioral economics that describes a common cognitive bias where investors feel more psychological pain when sustaining losses than they feel psychological reward when capturing gains. This is a very important concept to understand, as emotional responses to market volatility can lead to impulsive reactions that can be detrimental to long-term investment outcomes. We strive to ensure our clients understand the details of their investment strategy, as we believe adequate knowledge equates to confidence in financial plans and investment objectives.

Hedges have an important role when it comes to loss aversion. They are implemented using equity options in order to minimize losses during times of market volatility and avoid these impulsive reactions. Remaining invested is crucial, so our portfolios are able to capture gains when markets are outperforming.

Hedging in our Portfolios

We use hedging not only to minimize loss aversion but also to optimize our investment allocations for maximum returns. Properly implemented hedges give us the freedom to increase allocations to assets with higher return potential, such as an increased exposure to growth stocks or technology stocks.

Conclusion

The focus of our investment strategy is centered around reducing losses and controlling the impulsive reactions that come with loss aversion. Our belief is that remaining invested during periods of heightened market volatility is the biggest factor in being able to maximize investment gains. A focus on financial planning and long-term investment objectives will always remain paramount, and the prudent use of hedges naturally fosters this rational investor behavior.