By Andrew Horowitz

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Over the last two episodes, we have been discussing the concept of shorting stocks, which we do when we think the market or a particular stock is going to go down in value and we want to profit from this decline.  Short selling is just one way to hedge your portfolio.

In this episode, we will be discussing hedging, why it’s important, and under which circumstances you should consider hedging your portfolio.

What is Hedging?

Let's think of the concept of hedging like this.  You put a hedge around something when you want to protect it, right?  Think of the concept of "hedging your bets."  You still want to make a bet, but you want to try to reduce some of the risk in taking the bet... like buying "insurance" when the dealer flips over an ace card in blackjack.  Taking an umbrella outside on a cloudy day is a way of "hedging" yourself against a thunderstorm. 
When you hear someone say you should "hedge your portfolio,” think of the word "hedge" like the word "protection."  By hedging, we try to protect our carefully selected portfolio against the uncertainty of the future.

When you hear someone say you should "hedge your portfolio,” think of the word "hedge" like the word "protection."  By hedging, we try to protect our carefully selected portfolio against the uncertainty of the future.

Why Hedge Your Portfolio?

If for some reason we felt like the economy and stock market were about to decline very sharply, sort of like it did in 2008, then we would want to be out of as many stocks as possible and instead be invested in bonds or cash.  However, the stock market doesn't usually fall 40% or more in a year!

Instead of getting out of stocks completely, you would want to hedge a portfolio if you thought there were bumpy (but not devastating) times ahead.  Remember, the goal of building a portfolio of carefully chosen stocks is to hold onto it as an investment.  If you hold stocks for longer than a year, you will pay lower taxes on these "investments," whereas if you buy and sell a stock after holding it for a few months, you’ll may higher taxes.  That's why people want to hold on to stocks for at least a year before selling them.

When Should You Hedge Your Portfolio?

Strategies to hedge or protect your portfolio are best done in the "Goldilocks" area between a strong, rising market and a weak, falling market.  Hedging helps take care of the uncertainty and adds protection, but sometimes that protection can hurt you if you use too much of it... sort of like overpaying for an insurance premium that is designed to protect you if the worst happens.

If you try to hedge in a quickly rising market, your hedges will prevent you from making the most money possible -- that's no fun! That’s why you would not want to hedge a portfolio when the market was rising rapidly during a wide economic expansion. On the flip side, if you try to hedge in a quickly falling market -- like that of 2008 -- then the losses from your stock portfolio will be greater than the protection your smaller hedges give you.  So you would hedge when you still wanted to own stocks, but felt like perhaps the next few months might give investors a bumpy ride.

How to Hedge Your Portfolio

So how do you hedge your portfolio?  We'll discuss specific strategies professional-- and even smaller retail investors-- use when they're not scared enough to sell everything, but do want a little protection if the market does start falling slowly in the next few months.  Shorting stock is a way to hedge, selling call options is a way to hedge, buying put options is a way to hedge, buying inverse ETFs as we discussed in a previous episode is a way to hedge.

Stay tuned for the next episode where I walk you through the benefits of each of these methods when you want to put on some protection in your carefully selected portfolio!

Keep with us as we discuss even more ways to become a winning investor in our next podcast! If there’s a question you’d really like to ask, just email me at winninginvestor@quickanddirtytips.com  … And if you like the show, tell a friend or leave a review on iTunes. Until next time, this is Andrew Horowitz with The Winning Investor’s Quick and Dirty Tips for Beating the Market wishing you all the best on your quest to investment success.