Insurance, or hedging, is something we hear about an awful lot, but what does it mean relative to our world of investing? A good place to begin is using the following definition: Hedging is making an investment in order to reduce the risk of an adverse (very bad) price move in our portfolio.
When you think of a portfolio or stock hedge, think of your car insurance. Let's say you buy a $20,000 car and of course, before you drive that car out of the dealer's parking lot, you really want to have insurance on that vehicle. If you took out a loan in order to purchase that car, the folks lending you the money will insist you have insurance in order to protect their loan to you.
We just touched on one very important point. We want to protect the money we spent on that car whether it is our own money or somebody else's money. If we borrowed the money as most of us do when purchasing a large ticket item, we want to protect ourselves against a devastating event. After all, if a tree falls on our car while it is sitting in our driveway, we will no longer have a car, and we will still owe $20,000 to the nice folks who loaned us that money. By the way, those nice folks won't be so nice when they try and collect money from you, and you don't have it to give to them.
Back to insurance: If we had insurance on our car and the car becomes worthless because of a devastating event, the insurance company will pay back those nice folks who loaned us the $20,000. Then everyone ...