A hedge is designed to protect your investments – Image Credit: Robin Stott (CC by SA-2.0)
A hedge is an investment made to offset the risk of negative price movement in another asset. A hedge can be thought of as a kind of insurance policy that prevents a person from losing too much money when a particular asset plummets in price. For instance, a person investing in a luxury goods stock might also invest in a defensive stock as a hedge. In this case, the investor might choose to invest in a utility company since that stock will be more resistant to market changes. If the market as a whole experiences adverse movement, the luxury stock will likely drop, but the utility stock will likely remain constant. However, if market forces work in favor of the luxury stock, the investor will not make as much money as if they had invested fully in the luxury stock rather than investing some money in the utility company.
As seen in this example, hedging is considered a risk-reward tradeoff. As with an actual insurance policy, you must spend money in order to protect money in the future. Hedges can occur through diversification, such as in the above example, or through specific financial products designed to offset risk such as futures and derivatives. A perfect hedge, which is hard to find, will move in a complete inverse relationship to the original stock.
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