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Hedging Techniques Reduce Customers Financial Exposure
In certain situations, a financial advisor/broker may be liable to a customer for failing to recommend that the customer hedge their portfolio. Liability in this context usually arises when a customer has a portfolio concentrated in few companies or few industries leaving the customer open to devastating losses if those companies or sectors turn sour.
Brokers have a duty to provide investment advice suitable for the client and in the client's best interests. This includes a client's tolerance for risk and their ultimate financial goals. Hedging a portfolio helps reduce risks. If a client is not provided advice about the use of hedging in their account the broker may have some liability issues.
Liability for failure to hedge is a reflection of a broker's duty to make suitable recommendations that generally encompass the use of sound financial planning including diversification. In some situations, it would be unsuitable for a client to diversify a large holding in one or more securities; however, this does not discharge a broker's duty to make suitable recommendations, including a recommendation to hedge the portfolio.
The best way to understand hedging is to think of it as a type of insurance. When people decide to hedge, they are attempting to insure themselves against a negative event. This does not prevent a negative event from happening, but if it does happen and they are properly hedged, the impact of the event is reduced.
Some form of risk taking is inherent to any investment, no risk--no reward. Portfolio managers should use hedging techniques, in most cases, to reduce their customer's exposure to various risks. These financial advisors/managers should recommend helps reduce risks to avoid against investment risk by strategically using instruments in the market to offset the risk of any adverse price movements. In other words, investors hedge one investment by making another.
Technically, to hedge an investment two securities with negative correlations is made. Hedging does not address the risk-return tradeoff. A reduction in risk will usually mean a reduction in potential profits. Therefore, hedging, for the most part, is a technique where the customer will hopefully still make money but reduces potential losses.
Losses suffered because a broker failed to recommend an appropriate hedging strategy, may be able to be recovered by filing a claim.
