It seems that much of the business language we hear (and use) is hard to understand. The Rosetta Stone of business jargon hasn’t been discovered which would allow translation to an easily understood form. I love to study jargon, “terms of art” and language which are unique to the business world. One can discover a great deal about underlying motivations to use such language if you approach the study with a key question in mind: “Does the speaker gain more from my comprehension or from my confusion?” Why would confusion be advantageous to players of the game of business? We can learn by examining one particular word: hedging.
“Hedging” is one of those fascinating terms that have a long and rich history of use, misuse and abuse. The usual meaning of the word refers to the customary practice of anticipating price movements in commodities (currency, raw materials, crops, etc.) and betting to some degree in the opposite direction of the risks already accepted. Under a broad application, “hedging” can be said to describe a wide range of business activities designed for risk balancing. Examples include purchasing insurance, forward contracts for buying needed raw materials, and spreading investment risks across multiple industries in the venture financing industry. This last example is a reason why whole funds were created in order to make investment bets that were contrary to the principles of most mutual funds, at the time of their inception. Today, a “hedge” fund is difficult to distinguish from other types of pooled investment entities, because as time has progressed, the necessary risk balancing seems to produce about the same overall portfolio demographics. As the economists would say, the market is efficient; if a segment of the market discovers a knowledge advantage and exploits it (such as early hedge funds did), it is only a matter of time before the rest of the market acquires the same knowledge and the playing field is returned to its modestly rolling hillocks.
The early hedge fund founders liked to use this word to infer that they were a risk-balancing opportunity. Back to my first paragraph’s key question. It is to the benefit of the hedge fund founders that they be viewed as an attractive and effective investment vehicle to reduce the exposure that the hedge fund participant might face in another part of their investment portfolio. So the hedge fund representative is probably not the right person to ask whether or not the term still applies to their efforts.
The word has been rediscovered recently as the world faces dramatically variable commodity pricing, forcing businesses and aware individuals to consider making risk-balancing bets, i.e., to “hedge” against the probability of a negative result for their other ongoing business bets. But when did we quit calling it “gambling”? Isn’t commodity hedging exactly the same as playing the side bets along with the “pass” line at the craps table? For that matter, even the gambling industry changed their name. It’s not the “American Gambling Association”. It’s the “American Gaming Association”. Luckily, they didn’t have to change the monograms on the association executives’ shirts. “Gaming” apparently fared better in the parent and church focus groups. Sounds so playful, not like the addictive and destructive potential that gambling is known to possess.
The Merriam-Webster dictionary says “hedging” comes from the notion of encircling a plot of land by planting a hedge, in order to protect the land from erosion and incursion. So to the degree that risk-balancing bets do indeed protect one’s assets from erosion (depleted value on the market) or incursion (loss of strategic position), then “hedging” appears to be a fine term, if used as intended. The problem with applying the term comes in two forms. The first form is when we think we are balancing our risks through the purchase of one type of hedge or another, but we are actually introducing more net risk into our business recipe. We bet on the wrong things which don’t move counter to our existing bets. We get a big water buffalo to ensure that any trespassers are repulsed should they get through the barrier, only to find that the animals are eating the hedge.
The second form is when we commit the classic gambler’s mistake. We try to make up for prior bad bets by taking increasingly riskier positions because they have the (tiny) chance of making up for prior losses.
The bankrupted investment bank Baring was brought down by one trader: Gleason. He’s a poster child for this activity. I imagine that most of the sub-prime mortgage-backed securities characters hearkened to the “double down” siren, calling to those raptly attentive gambling addicts. How else can we explain triple-A ratings on collateralized debt obligations comprised of what the investment banking industry itself called “toxic waste”?
As Shakespeare once might have penned, “A gamble by any other name, stinks just the same.”