Definition: To follow an investment you have made with another one that will lessen your losses in the event that the original investment turns out to be unsuccessful.

Example: You purchase 100 shares of stock in XYZ Corporation for $50 per share. You now have 100 * $50, or $5,000 at risk. To hedge this investment, make a second purchase of something that will go up in value if XYZ’s stock falls in value. This is known as a put option, which you can learn about by looking up that term.

Investeach explains: In the normal course of their lives, people “hedge their bets” without even realizing they are doing so. Let’s say Jake, a high school senior with good grades and extracurricular activities, is applying to college. While he has a competitive enough case to be accepted to “reach” schools such as Harvard, Yale, or Princeton, or “target” schools like UCLA or the University of Illinois, he knows there is a possibility that he will be deferred or rejected from all of them. Rather than just hope that he gets accepted, he realizes the need to apply to “safety” schools in case he is rejected from his top choices. This will allow him to go to a college he likes rather than be stuck in a situation where no college has accepted him.

Why doesn’t everybody practice hedging? There is a definite cost to hedging. In the college example, there is an application fee, as well as a lot of time and energy spent on essays, interviews, etc. to apply to the safety schools. This time, money, and energy is lost forever.

Hedging can also be viewed as buying insurance. Consider why almost every homeowner buys homeowner’s insurance. People spend enormous sums of money on their homes. It’s a good bet that nothing will happen to their homes in any given year. Yet, the cost of losing one’s home would be devastating. So, they purchase homeowner’s insurance. That is their hedge.

Hedging is especially helpful when an investor has experienced an extended period of gains and wants to ensure he or she can “lock in” gains. They may want to extend the period of the profitable investment into a new year (allowing taxes on the sale of the investment to be owed a year later) or until it qualifies for the lower “capital gains” income tax rate.

Riddle me this:

  1. How do many adults “hedge” without realizing that they are doing so?
  2. Why do people choose not to hedge even when one is available?
  3. How can hedging be used to potentially defer (ie, put off) or lower an investor’s income taxes?

See related: Put option.

Credits: Kevin Wang contributed to this definition.