An Economist Walks Into a Brothel: And Other Unexpected Places to Understand Risk

by Allison Schrager

Hedging is one of the oldest and simplest financial strategies, but it is often neglected or confused with diversification. Diversification eliminates unnecessary risk by owning shares in lots of different assets; it could be pooling risk with other celebrity photographers or owning an index fund that contains lots of stocks in your investment portfolio. Your expected return is the same, but risk is reduced, because no matter what happens, odds are something you own will pay off. Diversification can eliminate idiosyncratic risk, but it does not help you with systematic risk like the entire stock market crashing the day before you are set to retire. Diversification helps you construct the best risky option, but you still have to manage the remaining risk. Hedging is determining how much of that risky option you want to or have to take to achieve your goal. And, unlike diversification, it comes at a cost. You must give up some of your expected gains, because you are taking less risk at the cost of less reward. Hedging is more precise because it takes more planning and a clear goal. It requires thinking through your goal, whether it’s more wealth, a career as a high-powered executive, or feeling good about your football team, and then doing something that reduces the risk that the goal won’t be reached. Hedging does not differentiate between systematic and idiosyncratic risk, but it can reduce both types.