Understanding the Hedge Fund Approach to Risk

Understanding the Hedge Fund Approach to Risk 5.00/5 (100.00%) 6 votes

Negating Short-Term Risk with Long-Term Profit
hedge fund investmentThe key feature that distinguishes a hedge fund from other types of investments is the willingness to exchange short term risk for long term profit. That should be the premise for many businesses but that is not always the case.

One would then wonder why is it that they do not follow this type of practice which could guarantee long term growth. The problem is that the model used by hedge funds is the ideal and many other businesses below them are not able to gather the same type of financial dominance of the markets.

The Small Business
If we take the case of a small to middle size business, we can see some of the challenges that would arise if we all attempted to implement the hedge fund model. Business discipline would inform the entrepreneur that they must always be willing to ensure that their short term interests do not prevent them from making long term profits. This type of discipline might involve foregoing the use of resources in the short term and also accepting personal hardship. These are not issues that necessarily affect the big businesses because they will have a diversity of income sources which they use to mitigate short term losses.

hedge fund long termWith the small business, once a problem is identified it has to be dealt with irrespective of the long term effects on the business. In fact the entrepreneur can make a calculated risk that if they do not deal with the short term problem, then the business can end up closing permanently. The hedge fund will face no such problems. First of all the people who invest in hedge funds will have so many resources from wealthy people that any short term problems can effectively be written off. The remoteness of the investor also means that their personal problems do not interfere in the overall running of the business.

Thus the hedge fund owners might end up making an investment which to all intents and purposes looks like a particularly bad decision for shedding money into. Although such decisions do not make sense to the ordinary investor, they do make quite a lot of business sense to the hedge fund investor because they are always looking to the future rather than the present. Their advisers will be able to obtain for them the best indication of where the markets are going so that even if problems arise, they will have anticipated them in the first place.

The Pressure to Make Profit
Hedge funds have added pressure to make profits because the investment managers involved may have their remuneration tied to the fact that they can make profits. As we all know, profits normally means risks. This drive to create profits can lead them to make too risky a decision where the ordinary investor would balk at the idea. In the economic downturn many hedge funds have made some losses.

However some of them have been clever enough to make the business case that they are far too big to be left to collapse. This has forced the domestic governments to intervene with even more concessions.