What Is Portfolio Hedging And Why It Is Necessary To Learn About It?

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What Is Portfolio Hedging And Why It Is Necessary To Learn About It?
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A lot of Indian investors have been observed to go into long-term stock investments using their own DMAT accounts or through Mutual Funds. Apart from their diverse backgrounds and businesses in different sectors, limited knowledge of trading and hedging makes them choose long-term investments in stock markets as the sole option.

After a short market survey, I found out that many people invest a significant amount of money in stock markets, but lack the expertise of using derivatives to earn consistent income and returns from them. Moreover, a fear of losing money, which is instilled due to their own past experience or the experiences of their acquaintances, coupled with a basic perception that stock markets are 'satta' or 'luck', makes them forego even the most lucrative strategies in these markets.

Now, what is this luck? It needs to have a definition, right? Is it simply the uncertainty associated with winning a 50-50 bet, or the fear that it's not a level playing field? In India, one could believe that the lack of concrete knowledge on whether Goddess Lakshmi has paid your home a visit after Diwali pujas is openly termed as hmm, 'luck'. If you win, you're lucky, and if you don't, you're not. Probably a higher budget on Lakshmi puja next year will bring the change. But with a 51-49 chance of winning the same bet, I don't think you can call it a bet won by luck. If you don't believe me, read a book on the game of blackjack and you'll realize how casinos earn their bread and butter on a success ratio of just 51%. They might lose out to a player, but in the long-run, they're still employing!

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Similarly, a stock price, in the long-run, moves primarily because of its own fundamentals. But in the short-run, its price can surge or fall due to many unaccounted factors. A change in political agenda, a new tax reform, a fall in foreign portfolio investments, a war in the middle-east; all can impact the sentiment of the market causing the price to fluctuate. Predicting these factors (a list of which could fill up a few more pages) with even 60% accuracy would make you a God-like figure. Even though the probability of any one of these factors occurring is low in the short-run, the sheer difficulty in calculating a logical response if something occurs is difficult. For example, consider the paradigm of a cricket match between India and Bangladesh. You can't predict the outcome of every ball. It depends on factors such as where the ball is bowled, where the fielders are placed, whether the batsman is in form, etc. However, if you have to predict the result of the match, you'd probably go with India provided you are not from JNU or a struggling actor from Pakistan. In this backdrop, if you place a bet on India's win and subsequently win the bet, would you still give credit to Lakshmiji? If yes, stop reading beyond this line, I reckon. This is not for you!

Moving forward with the example, if you have adopted the Warren-Buffet ideology, you'd say I will bet on team India through its thick and thin. This team is a blue-chip and will help me buy that mansion, my dream car, and the diamonds to impress my love. I don't care if Virat gets beaten on the next ball, but the team victory is inevitable. I now ask a question - how many of you have seen SRK and Ranveer in a Royal Stag ad with the tagline - "Jo hath lag jaye vo kya large, lekin large banta hai un hi chotti cheezo se, small milate jao large banate jao"? Essentially, what one can deduce from this is that every ball counts. A six gets team India a step closer to the win, a wicket of Bangladesh gets the bookie to provide better rates on their win. Reversing to context, a stock price also has to climb stair after stair before it gives you massive returns.

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Portfolio hedging focuses on people who have been investing in the markets for wealth creation. They know their stocks are going to beat all the benchmarks and win the World Cup. But what will happen on 1 | P a g e the next day of trade, they don't know and they don't care. Now imagine a situation in which you could bet against the tide? If Virat hits a 4, your team gets closer to a win, but if he doesn't, you get paid. Sounds like a win-win bet, right? But what if an 'upset' occurs – just like India's first T-20 game against Scotland during the 2007 World Cup? You were still taking the money home after the World Cup but in that first match, you lost some opportunity to make money.

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A replica of the above can be applicable on your stocks too. Indian stock markets provide tools called 'derivatives' which assist in hedging your portfolio against such anomalies. They pay you when the stocks are not going in your favor. Sounds simple? Yes, it is. Sounds like an opportunity? Yes, there is one. But is it easy? No. Suppose India has been bowled out for 100; will the bookie still give you a decent return on India's loss? Nope! Similarly, an Infosys stock bought at 1000 will not provide the same return on a bet to reach 1100 if the stock falls to 900. You need to find another bet. And in order to find the correct bet, you either need to spend time learning the technique or outsource the service to an expert.

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An expert can be so called if s/he can predict with a higher accuracy whether to hedge on Virat hitting a 2 on the next ball instead of a 4, or to leave the hedge since there is a greater chance of him hitting a 6. Both situations would give different kinds of returns depending on the probability of their occurrence. But at least you can predict Virat's innings with a higher probability than of a junior Kedhar Jhadav's. A similar strategy should be used on the blue-chip stocks in your portfolio to earn a consistent income using derivatives while leaving mid and small caps to steal away the game on their days.

For a detailed discussion or feedback, please feel free to drop a mail at ishaanbhatia31@gmail.com.

Dinner is on me if you can discuss both stocks and cricket. To all the readers, thank you for investing time in my first article.

Stay tuned and happy investing!

Article by Ishaan Bhatia, an Associate, Amatya Business Consulting Pvt Ltd

(P.S. - The views and opinions expressed in this article are the author's own)