Market or systematic risk - the risk that the overall stock market could decline - cannot be reduced through diversification but can be limited by hedging.
An investor's choice among many possible hedging strategies depends on the nature of his or her underlying holdings.
- A diversified portfolio of large capitalization stocks, for example, could be effectively hedged through the sale of an appropriate quantity of Standard & Poor's 500 index futures. This strategy would effectively eliminate both profits and losses due to broad-based stock market fluctuations. If a portfolio were hedged through the sale of index futures, investment success would thereafter depend on the performance of one's holdings compared with the market as a whole.
- A portfolio of interest-rate-sensitive stocks could be hedged by selling interest rate futures or purchasing or selling appropriate interest rate options.
- A gold-mining stock portfolio could be hedged against fluctuations in the price of gold by selling gold futures.
- A portfolio of import- or export-sensitive stocks could be partially hedged through appropriate transactions in the foreign exchange markets.
It is not always smart to hedge.
- When the available return is sufficient, for example, investors should be willing to incur risk and remain unhedged.
- Hedges can be expensive to buy and time-consuming to maintain, and overpaying for a hedge is as poor an idea as overpaying for an investment.
- When the cost is reasonable, however, a hedging strategy may allow investors to take advantage of an opportunity that otherwise would be excessively risky.