Natural hedges are techniques used by investors to lessen risk in one investment by making an investment in contrast to the original one. The idea behind this technique is that poor performance by the original investment can be offset by good performance by the second one, and vice versa. Investors use natural hedges to balance out risks in one environment by exposing themselves to another investment which is likely to benefit if that risk is realized. It is also a less-complicated manner of hedging than using intricate investment techniques like derivatives.
The reality is that there is no such thing as an investment without risk. For that reason, investors have always tried to find ways to minimize that risk as much as possible. One way to accomplish this is with a hedge, which occurs when one investment offers some sort of buffer against another investment going bad. Many investors and companies achieve their goals of lessening risk by the use of natural hedges.
It is important to understand that the concept of natural hedges involves making investments in two different financial securities. This is opposed to hedging achieved by making two contrasting investments on the same security. Many investors, for example, will buy stock in a company and then hedge that risk by opening up an option to sell stock in that same company, but this is not an example of natural hedging.
By contrast, natural hedges occur when two contrasting investments are made in different securities. On a simple level, individual investors may take out a natural hedge by buying bonds to reduce their exposure to the stock market. In general, stocks perform well when bonds do poorly, while stocks suffer when bonds do well. Having exposure to both markets limits the risk involved. Corporations that deal in foreign currency investments can hedge by investing in manufacturing in the areas where the currencies are active.
There are some downsides to the use of natural hedges. While using a hedge helps to eliminate risk, it also reduces the chance of a big return on investment. That is because the money gained on one side of a hedge will be offset somewhat by the money lost on the other side, thereby mitigating the profit potential of both. It is also important to realize that hedging cannot always eliminate risk. Certain catastrophic economic events can hurt all markets, which means that a hedge can ending up losing money on both sides.