Time and time again we mention when discussing investments the central role that risk mitigation plays in making sure your financial instruments are safe from loss.
With the market being inherently volatile, it takes a lot of effort and study in order to keep your investments as safe as possible from the debilitating effects of loss. There are plenty of techniques that investment trainers, as well as portfolio managers, will be more than happy to share with you.
One such technique is hedging. To summarize, hedging is the act of making another investment in addition to your main. The purpose is to offset any possible losses to your main investment as a result of volatility in the market.
In other words, if your main investment incurs a loss due to circumstances beyond your control, the hedge you’ve invested in will help to minimize or even replace that loss. It’s an advanced technique, but we’ll explain it here in as much detail as possible.
To better understand hedging, it’s important to comprehend what it can do to help you with your investments. Let’s say that you have invested in two software companies that we will call Link Inc. and Qubisoft Corp.
These two are competitors, so basically their prices will move in accordance to how the public perceives the image and the proficiency of the company in providing their products.
Adding to the scenario – Link Inc. is fairly new, but has recently released a beta version of an upcoming Facebook game. The game’s beta version receives a positive feedback, overwhelming even, from the Facebook users that have given it a try. It seems that Link Inc. is poised to make a lot of money from the game, particularly from advertising.
Qubisoft Corp., on the other hand, has somehow allowed itself to be overtaken and has not given out any innovative product for the past three years. With a new company poised to do better in terms of income (and possible dividends for investors), it is only natural that those that have bought stock in the company will leave it in favor of Link Inc.
Let us say you’re one of those that have invested in Qubisoft Corp. You’re going to incur a loss, a possible significant one when Link Inc. starts to get its price going up. How do you hedge yourself against this loss?
The answer is obvious, of course – you buy stock in Link Inc. while the price is still low. On the other hand, you can either hold on to your Qubisoft stock for a bit or just sell it outright if you don’t have any confidence at all in the company. You lose some stock, but you’re poised to earn more from Link Inc. when the price goes up in anticipation of a successful product release.
There are many other ways to hedge your investments. The beauty of that is the fact that each type of investment requires a more specific method of hedging, so you don’t really have to study too many principles in order to be able to hedge more effectively.
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