Although the terms hedging and diversification are sometimes used interchangeably, the two terms actually refer to different areas along a spectrum. That spectrum is the correlation of returns.
Hedging
In plain English, hedging refers to the process of holding one asset (such as a stock), and then also buying another asset (such as a put option) that offsets the risk of holding the first asset. The hedging asset should have a strong negative correlation with the asset you are hedging.
A “perfect” hedge will remove all risk, and all return. Financial hedging in the modern world traces its history back to the 1840s. The Great Plains were being settled and farmed. Grain was being grown for the Eastern markets. Farming is a very risky business, and the price of grain is, and always has been, very volatile.[1]
Farmers had enough risk, associated with weather and the growing of crops, that they didn’t also want price risk.
Grain buyers (for example, bakers, millers, and grain merchants) also ran businesses that had enough of their own risks that they didn’t want to bear the risk of grain prices rising.
Being “long” a commodity means owning the commodity and bearing the risk of the price of the commodity falling.
Being “short” a commodity means having sold (or sold forward) a commodity that you don’t own, and bearing the risk of the price of the commodity rising. Farmers were (and are) naturally long grain. Grain buyers were (and are) naturally short grain.
In the 1840s, farmers and grain buyers got together and founded the Chicago Board of Trade and developed first futures markets in the western world.[2]
A “perfect” hedge, then, for a long holding would be to hold a contract to sell exactly that amount, at some future date, at a fixed price. (For example, the grain farmers would want a contract to sell an exact certain amount of grain at a fixed price.) Producers and users of commodities often want their hedges to be as close to perfect as possible. Commodity producers and users, for the most part, seek to earn profits from factors other than the price change in the commodity they produce or use. So, they are happy with perfect or near-perfect hedges that remove that price risk.
Hedging Against Inflation
On the other hand, few investors desire a perfect hedge. Investors care about generating returns, and perfect hedges remove returns. Unlike farmers and grain buyers, investors don’t mind taking risk if that means getting returns. A perfect hedge would mean that return, in addition to risk, was given up.
Instead, most investors want a properly diversified portfolio that provides the highest expected return consistent with the amount of risk taken. In financial theory terms, investors want an efficient portfolio.
Nevertheless, people, including investors, continue to talk about “hedging” against inflation.
Inflation is the fall in the purchasing power of money. To qualify as a perfect hedge against inflation, an asset would have to increase in market value by the same amount that money loses purchasing power.
There is an investment that is sold as a hedge against inflation, and that is believed by many people to be a nearly perfect such hedge. That investment is TIPS. How useful are TIPS? We’ll look at that question next week. The answer may surprise you.
This post was written by Katherine Silk and Roger Silk. Roger D. Silk holds a Ph.D. in applied economics from Stanford, and is the author of the recently published book explaining inflation, Politicians Spend, We Pay, available here. Katherine Silk holds a MA in history from Stanford.
Click here for to enter a drawing for a free copy of the book.
[1] Ancient grain price records exist that allow us to see that price volatility is as old as the records of prices.
[2] There were futures markets in Japan from about 1730. But there was extremely limited interaction between Japan and the rest of the world until 1853 when Commodore Perry sailed his fleet of warships into Tokyo Bay. The stated purpose of the visit was to return shipwrecked Japanese sailors to Japan, and seek the return of westerners who had been shipwrecked in Japan.