What is the best way to hedge your investment portfolio?

Short Answer

Hedging your portfolio is important if you want to generate consistent long-term returns on your capital. Some of the classic methods to hedge your capital are to diversify, modify your asset allocation according to market cycles, and use derivative instruments like futures and options to hedge your portfolio.

Detailed Answer

Ways to hedge your investments

Investments mark the first step towards generating wealth in the long term. The more efficient you are in managing your wealth, the faster it will grow. A common question that investors have is how to secure my investments from any major adverse market conditions?

Although there isn’t a straightforward answer to that, there are certain ways in which you can hedge your investment. The ability to protect your investments in every market situation will provide good returns consistently. Some of the ways to achieve that are here.

1. Diversify into different asset classes

The easiest process to follow if you want to hedge your capital or investments is to diversify. Diversification essentials mean dividing your entire capital into fractions and investing them accordingly. This also helps you to divide the overall risk among different investments pools. Therefore, even if one of your assets doesn’t perform well for a period, the remaining assets will offset the losses.

For example, if you have 10,000 to invest, you can divide the entire amount into 3 to 4 chunks. As per your risk profile, you can allocate around 50% of your capital into equity-related investments, 40% into debt instruments (bonds), and the remaining 10% in other alternative investments like Gold, FDs, etc.

2. Follow a dynamic asset allocation process

After you have diversified into different asset classes, the following step is to review your investments regularly and tweak the allocation proportion accordingly.

To have a better understanding of the process, let’s assume you have 50% of your capital invested into equity and the remaining 50% in Debt instruments (bonds). Currently consider your equity investments provide excellent returns in a one-year period, which equates to a current proportion of 70% in equity and 30% debt. Here, you can simply book some profits in your equity portfolio and shift the excess capital into debt. You should also do the opposite when your equity portfolio goes down, transfer funds from debt into equity. By following this process, your returns will be stable, and you will be able to create consistent returns in the long term.

3. Create active hedges for your portfolio with the help of derivatives.

The third process is more suited to active market participants who already have some experience in derivative instruments. Derivatives like Options and Futures are leveraged tools that are extremely risky but at the same time are rewarding.

If you already have a considerable sum invested into equity, the best way to hedge the downside is to use options strategies, for example, a Cover Call Strategy, buying Put Options, Selling Call Options, etc. By using these strategies, the downside risk is capped whereas you can incur losses if the position doesn't go as per your expectations. Also, using derivatives is not recommended for beginners as these instruments need skills and practice and any mistakes can cause massive losses. Hence use them with your own due diligence and proper risk management.

Tagged With: equity investingdiversificationoptions tradingdebt securitiesequity securitiesstock market investing
Categories: Investment
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