What is the difference between hedging and diversification? How does each reduce risk?

Question

Hedging and diversification are both used for reducing financial risks, but what are the exact differences between these two?

Answer 1

Hedging - You have an investment and are worried that the price might drop in the near future. You don't want to sell as this will realise a capital gain for which you may have to pay capital gains tax. So instead you make an investment in another instrument (sometimes called insurance) to offset falls in your investment.

An example may be that you own shares in XYZ. You feel the price has risen sharply over the last month and is due for a steep fall. So you buy some put option over XYZ. You pay a small premium and if the price of XYZ falls you will lose money on the shares but will make money on the put option, thus limiting your losses. If the price continues to go up you will only lose the premium you paid for the option (very similar to an insurance policy).

Diversification - This is when you may have say $100,000 to invest and spread your investments over a portfolio of shares, some units in a property fund and some bonds. So you are spreading your risks and returns over a range of products. The idea is if one stock or one sector goes down, you will not lose a large portion of your investment, as it is unlikely that all the different sectors will all go down at the same time.

Answer 2

The difference is in the interrelation between the varied investments you make. Hedging is about specifically offsetting a possible loss in an investment by making another related investment that will increase in value for the same reasons that the original investment would lose value.

Gold, for instance, is often regarded as the ultimate hedge. Its value is typically inversely correlated to the rest of the market as a whole, because its status as a material, durable store of value makes it a preferred "safe haven" to move money into in times of economic downturn, when stock prices, bond yields and similar investments are losing value. That specific behavior makes investing in gold alongside stocks and bonds a "hedge"; the increase in value of gold as stock prices and bond yields fall limits losses in those other areas. Investment of cash in gold is also specifically a hedge against currency inflation; paper money, account balances, and even debt instruments like bonds and CDs can lose real value over time in a "hot" economy where there's more money than things to buy with it. By keeping a store of value in something other than currency, the price of that good will rise as the currencies used to buy it decrease in real value, maintaining your level of real wealth.

Other hedges are more localized. One might, for example, trade oil futures as a hedge on a position in transportation stocks; when oil prices rise, trucking and airline companies suffer in the short term as their margins get squeezed due to fuel costs. Currency futures are another popular hedge; a company in international business will often trade options on the currencies of the companies it does business in, to limit the "jitters" seen in the FOREX spot market caused by speculation and other transient changes in market demand.

Diversification, by contrast, is about choosing multiple unrelated investments, the idea being to limit losses due to a localized change in the market. Companies' stocks gain and lose value every day, and those companies can also go out of business without bringing the entire economy to its knees. By spreading your wealth among investments in multiple industries and companies of various sizes and global locations, you insulate yourself against the risk that any one of them will fail.

If, tomorrow, Kroger grocery stores went bankrupt and shuttered all its stores, people in the regions it serves might be inconvenienced, but the market as a whole will move on. You, however, would have lost everything if you'd bet your retirement on that one stock. Nobody does that in the real world; instead, you put some of your money in Kroger, some in Microsoft, some in Home Depot, some in ALCOA, some in PG&E, etc etc. By investing in stocks that would be more or less unaffected by a downturn in another, if Kroger went bankrupt tomorrow you would still have, say, 95% of your investment next egg still alive, well and continuing to pay you dividends. The flip side is that if tomorrow, Kroger announced an exclusive deal with the Girl Scouts to sell their cookies, making them the only place in the country you can get them, you would miss out on the full possible amount of gains you'd get from the price spike if you had bet everything on Kroger.

Hindsight's always 20/20; I could have spent some beer money to buy Bitcoins when they were changing hands for pennies apiece, and I'd be a multi-millionaire right now. You can't think that way when investing, because it's "survivor bias"; you see the successes topping the index charts, not the failures. You could just as easily have invested in any of the hundreds of Internet startups that don't last a year.