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Author: Alan Haburchak

Hedging Strategies Can Reduce Investment Losses

Financial losses suffered by investors because their broker failed to recommend an appropriate hedging strategy can be recovered. There are literally thousands of "typical" or traditional hedging strategies that stockbrokers utilize, or in some cases fail to use. There have also been numerous reports that brokers at times misuse hedging strategies.

In general, hedging strategies look for a "spread" between market value and theoretical or "true" value and attempt to extract profits when the values converge. As hedging is a strategy designed to minimize exposure to unwanted risks, while still allowing a portfolio to profit from investment activity, it is an important aspect to investing. It is highly recommended that investors discuss the use of hedging strategies with their stockbroker from the onset of any investment.

One common hedging strategy is the investment in a security a broker believes is under-priced relative to its "fair value". This investment is then combined with the short sale of a related security or securities. By "playing both sides", it does not matter whether the market as a whole goes up or down in value, only whether the under-priced security appreciates relative to the market. This strategy is often referred to as a "speculation in the basis," where the basis is the difference between the security's theoretical value and its actual value.

Some stockbrokers fear that by suggesting a hedging strategy to a client the concept will tarnish their professional reputation. However, it has been proven over time that if the basic strategies are fully explained to a client that most clients want to minimize their risk, not add risk.

Given that appreciation rates for equities, the last twenty years have been well above long-term averages, most investors are open to the concept of transferring price decline risks to others, if the strategies, including costs and fees are appropriate.

Many brokers who have clients with taxable portfolios do not consider hedging strategies for several reasons. Concerns include the time commitment, the complexity of the issue, and the fear of what other people, including the client or other advisors, might think of a stockbroker who recommends hedging strategies.

Some brokers believe that many clients are not financially sophisticated enough to make informed decisions about hedging strategies and therefore claim those concerns are the reason they did not recommend a risk management approach.

Ignorance on the part of the broker and inaccurate perceptions by others are not valid reasons for stockbrokers to not recommend that their clients include these legitimate risk management tools as a part of their portfolio strategy. Investment losses that occur because a broker failed to recommend an appropriate hedging strategy to a client may be able to be recovered.

Under defined duties and regulations, stockbrokers or dealers are required to recommend "suitable" investments and strategies to clients. In addition, investment advisors, who have more stringent fiduciary duties and standards, are obligated to seek investments and strategies that are in the best interest of the client. Risk management is a key component of investment strategies.

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