What is a hedge?

A hedge is a position established to offset the risk of adverse price movements in an investment or asset. For example, an investor might purchase a put option (the right to sell a stock at a set price) to hedge against the risk of a stock they own moving sharply down.

Most investors have heard of hedge funds. They take the concept of a hedge and instead of offsetting price movements to cut risk, they actually aim to profit from those movements.  

Here’s the strategy behind hedge funds: If the market goes up, the good stocks the fund holds “long” should rise more than the weak ones fall, so the gains on the good stocks should exceed losses on the “short” sales. Alternatively, if the market falls, the bad “short” stocks should fall more than the good “long” stocks, so gains on the short sales should exceed losses.

However, profitable short selling requires superhuman timing, and the inevitable mistakes can be super expensive.

Sectors of investing can be viewed as hedges as well. Resource stocks in particular will provide a hedge against inflation, because they gain directly from rising prices for the commodities they produce.

While we think it’s important for investors to know how hedges work, we feel you are far better off investing mostly in sound, dividend-paying stocks. And to pick those stocks, follow TSI Network’s three-part Successful Investor strategy:

1. Invest mainly in well-established companies;
2. Spread your money out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; the Consumer sector; Finance; Utilities);
3. Downplay or avoid stocks in the broker/media limelight.

Get the complete guide to Investing for Beginners and build wealth with a conservative investing approach—this free report. Find out what they are in our FREE investing guide, How to Invest in Stocks: Canada investor advice on building a balanced stock portfolio