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Hedging your bets in hard times
Megan McArdle
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TEXT OF COMMENTARY
Kai Ryssdal: Whether it's the kind the FDIC offers or the kind we all buy on our cars and houses, insurance is essentially a hedge. Paying for the peace of mind of knowing you're covered if something goes wrong. Hedging's one of those terms that's bandied around a lot by financial types. But commentator Megan McArdle says more of us ought to do it in the more mundane parts of our lives.
Megan McArdle: Times are a little tough these days. Most of us are feeling, in Tom Lehrer's words, a little bit like a Christian Scientist with appendicitis. So why not do what the big financial boys do -- hedge your bets? This technique is widely exploited in the financial world, but people rarely think to apply it to themselves.
When I was getting my MBA, people put a lot of stock in getting a full time offer from their summer internship. Toward the end of the summer, a few of us decided to hedge our net psychic wealth. We each put $75 into a pool. Those who got full-time offers lost their money, but gained a job. The people who didn't get offers got to divide the money.
Merrill Lynch didn't offer me a full time job, but I did get a lavish dinner at one of Chicago's best restaurants. I enjoyed the meal much more than I would have enjoyed working at Merrill Lynch.
There are lots of opportunities to do this in every day life. Start with your 401K. You've probably got a lot of company stock in it. This is exactly the wrong approach. Instead, you should buy stocks that do well when your company does badly. If you work at Nutrisystem, buy shares in Krispy Kreme. If you're an automotive engineer, short GM and invest the proceeds in Exxon Mobil securities.
The Case-Shiller housing index offers a similar opportunity. If you're saving up a downpayment, you can buy shares in your local index, which will pay off when prices rise. But if all your wealth is concentrated in your home, you should be able to short housing futures. If prices keep falling, you'll reap a profit.
Worried about the outcome of a major event -- a promotion, a house sale, even a marriage proposal? Why not find a few willing friends and bet against yourself?
This strategy offers a bonus well beyond mental peace--you may find out that your friends have a lot more confidence in you than you have in yourself.
RYSSDAL: Megan McArdle is associate editor at The Atlantic. She blogs there too.
This is not really a hedge is it?. Correct about a hedge being like insurance but it stops there. Insurance protects against the things that are out of your control. A hedge will limit your exposure not eliminate it.
If sound financial advice is the goal here why not diversify your portfolio? Do most of us really have time to "Hedge" against a market clearly in flux? Big business have multiple layers of MBA's to figure out what and when to hedge. I'm sad to say I do not.
Lady Lucy: You quoted an accurate definition of hedging, and you STILL got the analysis wrong.
A hedge will limit your exposure to an adverse outcome, yes. But limiting your exposure isn't the same thing as REMOVING your exposure. Getting $300 does not fully compensate you for not getting a full time offer (which, as you point out, might have an NPV many orders of magnitude higher), but it does partially compensate you, and that is precisely what a hedge is.
Or to put it in really short words - a hedge is a bet that pays off with bad stuff happens to you. NOW do you get it?
I don't think she knows what a hedge is. She is right that a hedhe is like insurance in that it limits your exposure to risk (like a homeowner's insurance policy should pay for a new home if yours burns down).
But her examples have nothing to do with limiting risk--they're all bets. For instance, her MBA friends decided to each put $75 into a kitty and those who didn't get full-time jobs split the money. So say she had 20 friend, so there's $1,500 in the kitty. Also say 15 summer interns are hired by Merrill, five aren't. Then the five unhired MBA student spilt up the $1,500, each receiveing $300. The $300 in no way compensates them, or makes them anywhere near whole, for they--like Megan--missed out on: hundred and hundred of thousands of dollars of annual income courtesy of Merrill Lynch--and maybe some hard work, which Megan doesn't want to do anyway.
That's not a hedge--it's a bet.
