Diversification. You probably have already heard about diversification. Webster defines diversification as, “to balance defensively by dividing funds among securities of different industries or different classes”. In other words, don’t put all your eggs in one basket. While diversifying reduces the likelihood that all of your eggs will get broken, it is still possible.
Transferring Risk. Since diversification may not provide adequate risk reduction, the next step would be to transfer our risk to someone else. Similar to buying an insurance policy on your home to protect from the risk of a fire or tornado, there are ways to transfer our investment risk to someone else.
Hedging. Webster defines hedging as, “a means of protection or defense”. Taking your umbrella with you on a sunny day would be an example of hedging. It probably isn’t going to rain, and we don’t really want it to rain today, but if it does, we have planned ahead for it. When investing, hedging serves the same purpose. If everything goes according to plan we may not need our umbrella, I mean hedge. But if it doesn’t all go as planned, we have something in place that can protect us from some if not all of our losses.
Bottom Line
Invest in managing your risk.
