Financial professionals are notorious for using words and phrases industry professionals understand, but this industry jargon can be confusing for clients who might not fully understand what they mean.
To help shed some light on these words and phrases, this month we are debuting a quarterly segment meant to help educate and bridge the gap between what is being said and what is being heard.
We welcome your feedback and would love to hear your suggestions for future installments.
Hedging is an investment technique designed to offset the risk of a negative event. Investors “hedge their bets” on one investment by investing in another.
You can think of hedging like purchasing an insurance policy. For example, while your auto insurance does not protect you from getting into an accident, it may protect you from many of the costs associated. Like auto insurance, hedging cannot stop a stock from dropping, but it can help insulate your portfolio.
Here is a simple explanation of how hedging works in the financial world. You believe that Stock A is going to go up, so you invest. However, you want to protect yourself just in case Stock A goes down, so you invest in Stock B because it has a negative correlation to Stock A, thus altering your exposure to risk.
Like auto insurance, hedging is not free. When you hedge, you are paying to reduce uncertainty. In other words, when you reduce your risk, you also often reduce your potential profits. However, losses can cost your portfolio more than gains can grow it, making hedging a useful technique for investors who want to limit their exposure.
While hedging is a familiar term to many investors, relatively few retail investors actively use hedging strategies. Our team believes they are quite timely and can often be quite beneficial!
A benchmark is a standard, or metric, by which any given security or group of securities can be measured.
You have probably heard of the Standard & Poor’s Index and the Dow Jones Industrial Average. These are benchmarks used to measure the overall performance of the stock market. Other benchmark indexes, including the MSCI and the Barclays Agg track non-US equity and the bond segments of the market.
Benchmarks can help investors put their portfolio exposure and performance into perspective. Individual investors also use benchmarks to judge their manager’s performance, both in absolute and risk-adjusted terms.
While benchmarks offer investors a useful way of measuring risk and reward, we firmly believe the most useful measuring stick remains your own personal investment return goal. If your portfolio needs to post a 6.75% net return for you to hit your goals, beating a given index is of little consolation if you didn’t achieve the 6.75% needed.
03 INITIAL PUBLIC OFFERING (IPO)
A company’s initial public offering — or IPO — is the first sale of a stock on the public market. A business’s IPO marks the transition from a private company to a public one, allowing potentially hundreds of thousands of people to become partial owners of the company, or shareholders.
IPOs for well-known brands generate enormous public interest and receive a lot of media buzz. They are attractive to some investors because IPOs represent chances to buy a small share of a company that could — one day — become much more valuable.
You may have heard about some of the recent and upcoming IPOs, including Slack, Airbnb, WeWork, Lyft, Uber, and Pinterest, and while it can be tempting to become a shareholder of one of these exciting companies, it is important to remember that even successful companies have struggled following their IPOs, including Facebook. In fact, in the year after it went public, Facebook’s stock price fell more than 50%.
It is common for a company’s stock price to go through extreme volatility in the days, weeks, or even months following its first day of trading. Because these stocks do not have a trading track record, it is difficult to predict when they will settle, making them risky for investors.
Before getting caught up in the hype surrounding an IPO, talk with your financial advisor to see if investing in an IPO makes sense for your portfolio.
We hope that these explanations help clarify some of the mysteries surrounding hedging, benchmarks, and IPOs. Next quarter, we will focus on more financial words and phrases that can be complicated for investors. We look forward to hearing your ideas for future installments.