A hedge is an investment position intended to offset potential losses/gains that may be incurred as a result of a particular risk or vulnerability. In simple language, a hedge is used to reduce any substantial losses/gains suffered by an investor or institution.
Hedging Against Inflation
Certain investments are very vulnerable to the erosive effects of inflation. Consider a treasury bond paying a fixed coupon payment. As inflation increases, this fixed coupon becomes less and less valuable.
On the other hand, certain types of investments are excellent hedges against inflation. Consider an investment in a rental property or a REIT. As inflation increases, the shrewd landlord will raise the rent charged to his tenants accordingly, thereby hedging his rental income against the effects of inflation.
Examples in Agriculture
Based on current prices and forecasts at harvest time, a farmer decides that planting corn is a good idea. Once the farmer plants corn, he is committed to it for an entire growing season. If the actual price of corn rises greatly between planting and harvest, the farmer stands to make a lot of unexpected money, but if the actual price drops by harvest time, he could be ruined.
A farmer can hedge the price of corn by selling a number of corn price futures contracts equivalent to his anticipated crop size. By doing this he can lock in the final price of corn at the time he plants his crops. If the price of corn increases at harvest time, he will have missed out on any unexpected profit, but if the price of corn dramatically decreases by harvest time, he will have prevented potentially catastrophic losses.
The information in this post was compiled by S. Zachary Fineberg, Managing Member of Fineberg Wealth Management, LLC, a registered investment advisor located in Ann Arbor, MI. If you would like to schedule a consultation to discuss how Fineberg Wealth Management can help you reach your long-term financial goals, please contact us by email or call (734) 230-7900.