Investing, hedging, speculating—what’s the difference?
The line between investing, hedging, and speculating is thin, even blurry sometimes. Differentiating between them and understanding their implications can help you stay on track to meet your financial goals.
What’s investing?
Investing is the act of allocating your money into assets (usually, stocks, bonds, and alternative investments) with the goal of generating a financial return through capital gains and/or income. It’s a long-term initiative that requires careful planning, monitoring, and adjustment.
Crucially, investing is about much more than picking the right assets in which to invest. It’s about understanding your personal and financial situation and establishing a plan based on realistic assumptions to meet specific long-term financial goals. It involves identifying the optimal asset and regional allocation to build an efficient portfolio and choosing diversified investments that have the right profile and expected returns to achieve the plan. It’s about understanding and accepting risks. Investing also requires removing any emotions from the process and not letting short-term noise cloud your judgement. Finally, it’s monitoring and rebalancing the portfolio regularly to stay on track, as well as adjusting the plan should market conditions or your situation change significantly.
Investing requires planning and execution
Source: Manulife Investment Management. For illustrative purposes only.
Investing can play an important role in most of our lives, but it also requires time and expertise—even for buy-and-hold strategies—to build the right strategy and monitor it.
An advisor can help you invest.
What’s hedging?
Hedging is the use of certain financial instruments that are often more complex—for example, options, forwards, futures, and swaps—to mitigate or even eliminate certain types of risks that come with investing in stock and bond markets. A hedging strategy is intended to reduce one or more of the risks in your portfolio. Therefore, it acts as a complement to an existing investment strategy (which is intended to generate returns). Currency risk, interest-rate risk, and default risk are examples of some risks that can be hedged away with proper use of hedging instruments.
It’s important to know that hedges are designed to reduce specific risks, rather than to generate returns. Because of this, they can result in a gain or a loss. For example, a successful currency hedge for a Canadian investor with an exposure to the S&P 500 Index would’ve gained 0.68% in 2021 but lost 0.53% in 2020. In other words, this investor would’ve generated a gain from the hedge in 2021 but a loss in 2020. However, in both years, the risk the investors faced (specifically, currency risk) was reduced.
Successful currency hedge would remove the impact of currency movements, both on the upside and the downside
Yearly returns of the S&P 500 hedged and unhedged indices (%)
Source: Manulife Investment Management, Macrobond. The indices cited are widely accepted benchmarks for investment performance within their relevant regions, sectors, or asset classes, and represent non-managed investment portfolios.
An important point: implementing hedging strategies is much more complicated than trading stocks. For this reason, many hedging instruments are available only to the most sophisticated investors, mainly institutions. While there exist strategies that are managed by investment professionals with various embedded hedges, it’s important to analyze the underlying methodologies to make sure you choose the strategies that best suit your needs.
An advisor can help you identify the risks to which you’re exposed, and if and how they can be hedged away.
What’s speculating?
Speculating is the act of interacting with financial markets with one goal in mind: generating short-term gains. Overlooking risks—sometimes big ones—while chasing extraordinary returns, speculators are the main reason why “gambling” and “betting” are two words often associated with financial markets and too often mixed up with investing.
Speculators tend to trade more frequently, attempting to time the market. In hindsight, every decision and market event can seem obvious, but in reality, financial markets are unpredictable, and trying to time the market has proven to be all but successful over the long term.1 For example, 2021 was a great year for stocks—with the S&P 500 Index returning more than 25%—and the temptation to sell along that great run was real as prices and valuations were getting higher and higher. However, the Index remained strong all year, and a speculator missing only the best five days of the year would’ve left more than 10% on the table.
Value of staying invested—S&P 500 Price Index
2021 return profile under various scenarios
Source: Manulife Investment Management, Capital Markets Strategy, Bloomberg, as of December 31, 2021
Speculators also tend to make decisions based on others’ opinions, which may not result in rational decisions as chasing quick gains and fearing of missing out can fuel impulsivity. Moreover, with the rise of financial content on forums and social media platforms, investors need to be more careful than ever, as speculating can get out of proportion. In 2021, for example, speculative trades made headlines as online forums hyping so-called “meme stocks” gained so much traction that it even became a risk to the broad market, and many brokerages had to restrict trading in those stocks.
A prudent advisor wouldn’t help you speculate but can help increase awareness.
1 Henriksson, Roy D. “Market Timing and Mutual Fund Performance: An Empirical Investigation.” The Journal of Business 57, no. 1 (1984): 73–96. http://www.jstor.org/stable/2352889.
Important disclosures
Investing involves risks, including the potential loss of principal. Financial markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. The information provided does not take into account the suitability, investment objectives, financial situation, or particular needs of any specific person.
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