Hedging Your Investments

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Hedging Your Investments
by Rande Spiegelman, CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research
Updated January 13, 2009

When you hear the word hedge, you might imagine a row of shrubs that form a boundary around a yard. Or maybe the phrase "hedge your bets" comes to mind.

When it comes to investing, a hedge is simply a strategy to defend against financial loss, particularly if you have an overly concentrated position (which can be more like a bet than many folks realize). For example, if you have a large amount of a single stock as a result of your company's IPO, executive compensation or an inheritance, hedging might make sense.

Investment hedges can also be used to offset potential losses in part or all of a diversified portfolio when you're temporarily unwilling (or unable) to sell. For instance, if you have a large portfolio and you're worried the bottom may drop out of the market—but you don't want to sell and incur taxes on your gains—you might enter into a temporary hedge to protect your positions.

To be effective, a hedge should meet three basic requirements:

The hedge must make investment sense.
The hedge must be tax-effective.
The hedge must make sense considering all costs involved, including opportunity costs and the timing of cash flows.

How do I know if I have a concentrated position?
If a single stock makes up a disproportionate amount of your portfolio, you have a concentrated equity position.

In the equity portion of a well-diversified portfolio, investors typically try to eliminate what the financial pros call nonsystematic risk—the risk of investing in a specific company. This generally means investing in a number of companies across various sectors and industries, with no more than 4% to 5% (preferably 2% to 2.5%) of your total equity exposure represented by any one company's stock. Anything over this amount could expose you to more risk than you're comfortable with—above and beyond a certain level of nondiversifiable systematic risk (market risk) you can't get rid of.

According to work done by the Schwab Center for Financial Research, you should be concerned if a single stock accounts for 10% or more of your total equity exposure. And alarm bells should really start ringing if that number jumps to more than 20%.

This all assumes the rest of your portfolio is adequately diversified and your overall equity position is a significant part of your portfolio. For example, if your portfolio is only 10% stocks, a concentrated position may not be as much of a concern relative to your overall wealth.

Sometimes a sale or gift is a better strategy than hedging
Before you consider any hedging strategy, think about whether an outright sale or gift would make more sense. Sometimes the best strategy is to take your gain, pay your taxes and move on. The sale could take place all at once, or you could average out of your position over time, spreading the realized gains over more than one tax year.

Another viable strategy is to gift appreciated long-term positions to qualified charities for a full, fair-market-value tax deduction (subject to adjusted gross income limitations) and no capital gains tax. Gifting appreciated assets to children 19 or older—who could be eligible for the 0% long-term capital gains rate¹—can also be a tax-effective way to diversify out of a concentrated position.

Still, while an outright sale or gift can often be the best way to go, there are any number of reasons to consider hedging as an alternative:

You definitely plan on selling but want to defer recognition of your gain to a future tax year. Hedging can protect your position while you wait.
You're not sure about selling. You believe your position could decline in value, but there's also a chance it might appreciate. A hedge could give you more time to objectively evaluate the situation.
You need cash but don't want to sell your position. Hedging may allow you to borrow on more favorable terms.
You might be in very poor health and want to protect the value of your assets without having to sell prior to death. A hedge might allow you to avoid capital gain taxes now while protecting your position until the time your heirs would receive a step-up in cost basis on the inherited assets.
You might face company or regulatory restrictions that prevent you from selling, such as a trading window, post-IPO lockup period or insider trading rules. In a case like this, first find out if your company has a "no hedge" clause, and always consult with a securities law attorney or in-house counsel on regulatory matters, if applicable.

Get expert help
Hedging has a number of tax consequences, which we discuss in "Hedging: Tax Traps for the Unwary." If you're considering a hedge, we strongly recommend getting expert help, preferably from both your trusted investment professional and tax professional working together.

We also take a look at some specific hedging techniques in "Strategies for Hedging and Diversification."

Important Disclosures
1. For taxpayers in or below the 15% ordinary income tax bracket, the long-term capital gains rate is 0% through 2010. Children under age 19 pay tax on unearned income in excess of $1,900 at their parents' rate. Full-time college students under the age of 24 are also taxed at the parents' rate on unearned income in excess of $1,900, unless the students' earned income is greater than one-half of their support.

The information is not intended, and should not be construed, as a specific recommendation, or legal, tax or investment advice, or a legal opinion. Individuals should contact their own professional tax advisors or other professionals to help answer questions about specific situations or needs prior to taking any action based upon this information.

The information presented does not consider your particular investment objectives or financial situation and does not make personalized recommendations. This information should not be construed as an offer to sell or a solicitation of an offer to buy any security. The investment strategies shown may not be suitable for you. We believe the information provided is reliable, but Charles Schwab & Co., Inc. ("Schwab") and its affiliates do not guarantee its timeliness or completeness.

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Does hedging make sense for you?

Call Schwab's Strategic Trading Group at 877-464-3343, or email a specialist.

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