Hedge Your Bets image

Hedge Your Bets

The importance of insurance in investing

Over the last couple weeks, I've written about the importance of cash flow ("Two Types of Investment Income" and "Four Reasons to Love Two Words"). And while I absolutely love investing for cash flow, and enjoy capital gains when they result from my cash flow investing, there is also a third and important way to invest: hedging.

What is hedging?

When I talk about hedging, I'm not talking about gardening, though the concept isn't too far off. When it comes to a garden, you build a hedge by planting shrubs close to one another to form a fence or a boundary. When it comes to investing, a hedge is like insurance. It is used to offset possible losses. It's like a financial fence for your investments.

For example, with every rental property I own, I create a reserve account. The reserve account ensures against unforeseen repairs and drops in income. The money is set aside to cover emergency expenses or a loss of rental income in case the tenants move out; it is a hedge against those losses.

We have a large commercial property with one tenant. If this tenant moves out before their lease expires, we are left with a gaping hole in our income, which we use to pay our mortgage. We would then be at risk of losing the property. The reserve account we have on this property is a hedge, or insurance, that if that happened, we could still pay the mortgage.

Types of hedges

Silver and gold are two examples of a hedge. Robert and I buy gold and silver not because we think the price will continue to rise, but instead mainly as a hedge against the dollar losing its value. Historically, when the dollar declines in value, people look to real money, such as gold and silver. Generally, when the dollar goes down in value, the price of gold and silver goes up. To us, gold and silver are a hedge against the devaluing dollar. We buy gold and silver to offset possible loss of purchasing power of the dollar.

Stock options are another hedge that investors use. A stock option is the right, but not the obligation, to buy a stock (a call) or to sell a stock (a put) at an agreed-upon price within a certain time period or on a specific day.

A stock option is a hedge because, if you buy a call option, you are betting that the price of that stock is going up. The price of the option is a small fraction of what the actual stock would cost you to buy. For instance, the stock may be selling at $30 per share, but the option might cost only $1. If the price of the stock goes down $10, then you forfeit the cost of the option at $1 per share instead of losing $10 per share. The option is a hedge against possible losses. Of course, if the stock does go up, then you can use, or exercise, your option and buy the stock at the lower agreed-upon price. Stock options are a science all to themselves.

Why hedging is key to success

At the end of the day, hedging is not an investment strategy in and of itself. Just like real insurance, you don't need it unless you're doing something else. For instance, if I don't own a home, there is no reason to own homeowner's insurance. When it comes to investing, if I'm not putting my money to work in assets, there is no reason to hedge my investments.

So, the first thing is to start investing for cash flow. Once you do that, you may experience capital gains. And for both types of investing, you should always be looking for a way to hedge your investments to protect against losses. That is how the successful investors always invest.

There are a ton of resources we offer to help you learn this important investing principle. I encourage you to read books like Rich Dad's Guide to Investing and Rich Dad Advisor Andy Tanner's Stock Market Cash Flow. We also offer a range of classes on investing strategies, including hedging, through Rich Dad Education. And, of course, everyone can use a good coach.

However you approach your financial education, the most important thing is to start doing something! Today is the day to begin investing for your future.

Original publish date: September 26, 2013