Hedging at home: Strategies for the everyday investor

When we hear about hedge funds we often think of over-leveraged, high-flying money managers taking big risks with other people’s money.

In fact, an investment hedge is the opposite. By its strict definition it is used to reduce risk by taking one position to offset another position. A perfect hedge reduces risk to nothing, but it also wipes out any gains.

A less-than-perfect hedge strategy in your portfolio should reduce risk while maintaining the opportunity for gain. Here are a few home-made hedges:

Household harmony

You may have heard the story of the husband and wife who both worked at the former Nortel Networks and both had pensions consisting entirely of Nortel stock. When the company went bust, they went bust.

We often can’t help where we work but we can try to avoid investing in the same company or sector. Company share programs are great when the company matches your contribution or waves fees, but look into the terms for cashing out every year or investing in an unrelated sector.

Auto, house and life insurance are useless until you need them. Make sure your policies are up to date and fit your needs.

Many Baby Boomers nearing retirement are finding returns on their investments are too small to meet their income goals. Take advantage of the sluggish economy and low interest rates by diverting some of those investment dollars toward paying off debt.

Paying down a mortgage is also an investment in real estate, which has proven to be a good hedge against volatile stock markets.

Portfolio diversification

Hedging is what separates gambling from investing and diversification is the best hedge for long-term investors. That’s why it is important spread your portfolio around the world and across many sectors.

The best performing stocks so far this year are Japanese equities and health care stocks, and the worst are resource-related stocks. The opposite was true over the preceding five years. Investors who chose the best in each sector have maximized the benefits while limiting overall risk.

Government bonds and other safe fixed income securities may be paying low yields right now but at least they are paying. Anyone who bore the brunt of the 60 per cent drop in equities in the 2008 meltdown knows the value of wealth preservation.

Investment experts recommend a mix of stocks and bonds to keep a portfolio growing and cushion the blow of a market shock. That mix depends on how much risk an individual is prepared for, and how soon they will need to rely on those funds in retirement.

Tax hedge

One of the biggest threats to a registered retirement savings plan (RRSP) is the risk that your tax rate is higher taxes when the funds are withdrawn, from when the contribution was made. This could happen if too much is contributed, the fund appreciates too much, or the government raises taxes.

The risk of paying too much to the government in retirement can be offset in two ways. The first is through a tax free savings account. Unlike an RRSP, money contributed to a TFSA cannot be deducted from income tax. However, unlike and RRSP gains on a TFSA are never taxed.

The right mix of RRSP and TFSA contributions will allow retirees to keep RRSP withdrawals in a low tax bracket while maintaining a decent living standard with tax-free funds from a TFSA.

The second tax hedge applies to homeowners whose property values have increased over the years. Like a TFSA any gains above the original purchase price are not taxed.

Homeowners have the ability to live off the proceeds of the house when it comes time to downsize, or borrow against the equity while they are still in it - tax free.

That makes your home itself a home-made hedge.