Investors looking for ways to reduce risk in their portfolios, and create consistent returns need look no further than hedge fund managers. These people are pros at creating consistently strong returns. While they each use different strategies to accomplish this, there is one technique they all use – “hedging”.
Hedging is a way of balancing risk. At its most basic, hedging involves balancing one risk against another. For example, if you buy a stock in two competitors, betting that one will do better, you are “hedging” your investment in Company A with your investment in Company B. This way, no matter which brand emerges as the leader, you come out on top. In doing so, you won’t get the same gain as if you had just bet on a single stock and that one was the champion, but you also won’t lose as much if you pick the wrong one.
In other words, you aren’t putting all your eggs in one basket. Hedge fund manager David Einhorn, Greenlight Capital plainly used this technique in buying a stake in Microsoft (MSFT) that is roughly equal to his one in Apple (AAPL) when it comes to the value of the position (see David Einhorn’s entire stock portfolio here).
Using the principle of hedging, you can create balance in your investments and make strong consistent returns more likely. The technique is so valuable that an entire class of investments, called “hedge funds”. Obviously, other types of investments use this strategy, be it a portfolio manager handling an individual investor’s interests, a pension fund or a mutual fund. Hedge funds are a little different. They operate by different rules and can use other types of investments than just stocks to hedge their portfolios.
CREATING CONSISTENT INCOME
Hedge funds may use real estate, currencies, commodities, bonds, private equity and much more in addition to publicly traded equities. Take George Soros’ Soros Fund Management for example. Of the top 20 positions in his portfolio, 9 were bonds at the end of the second quarter (check out George Soros’s portfolio here). Bonds allow hedge fund managers to profit from principal appreciation and interest income. This helps reduce the volatility of the fund’s earnings.
MAXIMIZING RETURN WITH DIVIDENDS
Dividends can also stabilize returns. Whether you take the dividends as they are paid or roll them back into the investment, dividends can substantially add to the value you receive from an investment and the dividends can help offset poor performance. So, even when things are bad, they aren’t that bad, and when they are good, they are really good. Many big name investors use this technique as well. Look at Warren Buffett’s Berkshire Hathaway for instance. Of the top 10 holdings in Berkshire Hathaway, all of them pay dividends – all of them (see Warren Buffett’s top holdings here). That has to tell you something.