December 28, 2014

The Difference Between Hedging and Insurance

Know the difference between hedging and insurance. They serve similar purposes, but they are not interchangeable. Hedging allows for gain. Insurance does not. Insurance is regulated by state agencies. Hedging is not.A whirlwind picked up this shed, moved it 20 feet and dropped it on a barbeque pit. Insurance paid to replace the shed and the barbeque pit and to fix a fence the shed damaged.

What Hedging Is

Hedging is an investment strategy you can use to protect yourself from losses and increase your potential gains in the stock market. At least one other person or company has to enter into this strategy with you, and they are called the counter party. There are many different ways you can hedge your investments, but they all consist of agreements between you and the counter party.

No government agency guarantees these agreements. If any of these counter parties fail to hold up their end of the deal, your only recourse is the court system. You can increase your level of protection by hiring an attorney to help you execute written contracts with the counter parties. However, this increases your expenses and still does not guarantee you will keep your money.

Even when you hedge your bets, you are still gambling.Insurance paid to repair this fence. A whirlwind threw a shed into the fence.

What Insurance Is

Insurance is a risk management strategy you can use to cover your risk of loss from theft, fire, car accidents, sickness, injury, flood, weather, vandalism and many other factors–in some cases including market movement, especially for farmers. You are not supposed to gain from an insurance claim, only to recover insured losses.

You buy insurance from a company licensed by the state, and the state regulates insurance. Most U.S.states cover the losses of customers in the event their insurance company goes out of business. Most judges automatically side with the customer in court cases between insurance companies and their customers. (More below this video)

Video: Hedge Fund Strategies and Nest Egg Protection for the Common American, by Hedge Strategies

Hedge Strategies explains that hedge funds have been used incorrectly. He says they were designed to protect investments, not to grow investments quickly. He explains how to use hedge funds correctly. He points out the lagging indicators of a recession: collapse of credit, nationalization of banking and insurance companies, economic stabilization legislation, news and stock market technical indicators.

Sources

I am expert at the insurance end of things, but here are the hedging sources I used to write this article:

“Hedging,” by Fred Wilson of Union Square Ventures – With clear examples, Mr. Wilson explains the hedging options of shorting stock, putting stock, and calling stock. He demonstrates the mechanism of counterparty risk inherant in hedging. He mistakenly calls the collar approach of buying a put and selling a call “insurance,” though, which is confusing.

“Insurance & Hedging: Two Ingredients for a Risk Management Recipe,” by the USDA – The USDA points out that Farmers have a natural hedge because the two factors that most influence their profits, price and yield, tend to balance each other out. If one goes up the other tends to go down. However, the USDA points out that farmers still need insurance because of other risks such as fire, flood, storm and theft.

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