Hedging is old wisdom in a new bottle

If you are not sure about the direction of the market, hedging is a mechanism that allows you to minimise the risk. You can never eliminate the risk in any investment.

Published: 07th September 2020 11:54 AM  |   Last Updated: 07th September 2020 11:54 AM   |  A+A-

For representational purposes.

Express News Service

Most of us are risk-averse by nature. Nobody likes to lose money. That perhaps explains the meagre participation in the stock market by the Indian public. Only 2 per cent of Indians are proud owners of a demat account. The rest cling mostly to physical assets like property and gold.

Uncertainty is the most significant dampener when it comes to equity markets. Share prices are rallying at a time when people around you are struggling to make ends meet. Many of you may ponder over the situation. It is not just an India phenomenon. It is happening in developed markets like the United States too.

In stock market parlance, they call this share prices running ahead of fundamentals. For most people not aware of these nuances, the best strategy is to stay away. But, there is a hefty price you pay for staying out. It may not be today or tomorrow, but years later.

By staying out, you do not allow yourself the benefit of the power of compounding. As your money grows over the years, it starts to make money for you. That is the primary reason why the public provident fund or PPF is such a successful scheme.

Regular 15-year investment in a PPF scheme gives you a pool of money mostly due to the compounding interest factor. The interest in it generates more income for you than the principal amount as you head closer to the 15th year. The government guarantees the PPF return.

However, as interest rates decline, the guaranteed returns are falling every year. We need low-interest rates for economic growth for a long time. So, expect the PPF guaranteed return to go down consistently every year.

A reason for you to invest in equity markets through systematic investment plans is that an investment in reliable businesses over 15 years can generate twice the return that you generate on the PPF deposit. However, stock markets are shaky, volatile and do not follow a linear path in their growth trajectory.

In September 2005, Hindustan Unilever shares traded at Rs 169. Today, the share price is Rs 2,131. You return over 18 per cent every year. You can use freely available multiple calculators to determine the exact return generated by the company’s share. Now, you may think about risking your savings into one such company. It is reasonable to doubt.

If you are not sure about the direction of the market, hedging is a mechanism that allows you to minimise the risk. You can never eliminate the risk in any investment. You can only minimise it. In such a situation, you hedge your risk. Diversification into more stocks is an excellent first step.

It minimises the chance for you. So you may choose more companies in India’s consumer sector for your long-term investment. If you pick the 30-share S&P BSE Sensex, your return may be 11.25 per cent but hedged due to diversification.

If you bet on a few stocks, it may be a good idea to hedge your exposure through options in the derivatives market. They are like an insurance premium you pay against a potential downside. If you think stock markets are likely to continue to slide and you are buying more into your chosen stocks, you could buy Nifty index put options or of those stocks you are regularly investing. It may be a good idea to talk to your financial advisor before doing something like that.

Your stockbroker will give you all the information about hedging your portfolio. A relationship manager from your stockbroker can walk you through the process. Current circumstances are such that investors are hedging in the derivatives market as well as they are buying gold. Gold prices and equity shares rarely rally at the same time.

At some point in time, share prices may fall sharply. So hedging is not just about using derivatives. You are hedging to protect your finances. That could happen through diversification of investments into multiple asset classes. After all, our elders have often asked us not to put all eggs in one basket. Hedging is a modern-day process just for that.


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