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Hedging vs Diversification

Hedging and diversification are related concepts in the sense that they both aim to reduce risk, however they do this in different ways, have different goals and are applied for different reasons.

Correlation

An understanding of correlation is required before getting into hedging and diversification. A detailed article which explains stock correlation can be found here: What is correlation.

To summarize, correlation ranges between -1 and +1. Positively correlated stocks tend to move together while negatively correlated stocks tend to move in opposite directions. Stocks with low correlations to each other tend to have no relationship in their movements.

Diversification

diversification

When diversifying a stock portfolio you will typically be looking to add positions which have low correlations to your existing positions. This means you will be looking for stocks that have neither a strong positive nor a strong negative correlation to any of your existing positions.

The goal is to have many positions in your portfolio which move independently thus limiting the chances of large losses as a result of highly correlated positions dropping in value simultaneously. This has the effect of lowering your portfolio volatility and smoothing your returns.

A more detailed article on diversification can be found here Why diversify your stock portfolio.

Hedging

portfolio hedge

When you are looking to hedge a portfolio you will typically be looking for negatively correlated positions. This means you will be adding positions to your portfolio which move in opposite directions to existing positions.

If a portfolio has been perfectly hedged, the resulting portfolio profit or loss will be zero. In other words, as your original positions move up (or down), your hedge will move in the opposite direction resulting in no change to your overall profit or loss. There may be times when you wish to only partially hedge your directional market exposure, meaning your portfolio will still be affected by profits or losses but to a smaller extent than what it would have occurred if unhedged.

There are many reasons why investors hedge their portfolios at certain times. For example if an investor feels the market is currently over extended and may be due for a downside correction, they may initiate a hedge for their portfolio instead of closing their positions. One way to achieve this would be to buy put options which will profit from a market downturn.

Another more advanced use of hedging is used in long-short portfolios (and hedge funds). Portfolios are actively managed in such a way as to always have equal risk to both the downside and upside. In other words several long stock positions will be open which benefit from an increase in price. Simultaneously, several short stock positions will be open which benefit from a decrease in price. The risk at any given point in time to the upside is specifically calculated to be equal to the risk on the downside.

Summary

hedging vs diversification

Diversification focuses on low correlation positions in an effort to smooth returns and reduce portfolio volatility. Portfolio diversification is a strategy that should be used at all times because it allows you to reduce portfolio risk while maintaining expected return. In other words, you keep all the upside profit potential of your positions but you reduce the risk of your overall portfolio.

Hedging on the other hand focuses on negatively correlated positions in an effort to eliminate (or vastly reduce) losses. Hedging is often only used at certain times when an investor decides that it is appropriate. There are however more advanced strategies which incorporate portfolio hedging constantly as part of a long-short methodology.

Tools like the Portfolio Analyzer and Stock Screener can be used to help find positions to either diversify or hedge your stock portfolio.

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