Fear and uncertainty. They are major short-term market drivers. Wall Street recognized this a long time ago and created tools so that they could profit from investors' fear and uncertainty. Enter hedges. Now whenever investors have a nervous inkling, they can purchase a security that will act as a counter-weight in their portfolio. The reason hedges are such a gold mine for Wall Street is that they drive up costs (in addition to brokerage fees, there are also holding fees associated with hedges), and encourage a higher number of transactions.
As an individual investor, it just does not make sense to have hedged positions. Even if you throw out the additional expenses and transaction fees, hedges are still poor investment choices. Look at it this way. Pessimistic Paul has $100,000 to invest, and he decides to hedge 10%. A good hedge will move in the opposite direction of the rest of your portfolio. Now he has $90,000 working for him, and $10,000 working against him. The net effect of this is that for his $100,000 investment, he only has $80,000 working in his favor. If his underlying investment increase in value by 10%, then instead of seeing and 10% gain, he will only see an 8% gain. Thus Paul is guaranteed to underperform the market whenever the market is moving up. On the flip side, it is true that Paul will lose less when the market moves down. However, in the long-run the market has always increased in value, so betting against it is like betting against the house in a Casino. You may win a few times, but if you stay at the table long enough, you will lose.
In extreme cases, such as the 2007-2008 financial crisis, where you would expect the hedges to really pay off, they still fail to meet expectations. In a paper for Journal for Financial Intermediation that actually is arguing for hedging, they state that "The reason for overall under-performance in the crisis period is that while short position taken by these funds do generate alpha, the gain from their short position is not sufficiently large to offset the loss from their long positions." The fact that hedges will underperform exactly when you need them most shows why they should be avoided as an investment tool. (Huang and Wang)
Let's say recent events have caused you to believe that a particular industry you are invested in will decline. There are three choices available. You can hedge your investments, sell them outright, or do nothing. Selling and doing nothing are both viable options. You should make your choice based on what you think the long term fundamentals of the industry are. The only reason you should hedge is if you think the industry will underperform the market in the short term. The problem with this option is that it assumes you know what the stock market is going to do in the short term. Personally, I don't put much faith in anyone's ability to predict the short-term fluctuations of the market.
There are certain situation where hedging is valuable. It makes sense that a company like McDonalds (NYSE:MCD) would want to put a hedge in place against the rising price of beef. They want their success or failure measured on their performance executing their business plan, not a variable outside of their control. The same is true with fuel hedging in the airline industry. As a low-cost carrier, Southwest Airlines (NYSE:LUV) has excelled in a historically unprofitable industry. It wants its continued success to be based its ability to provide low-priced flights in a fun-to-fly atmosphere, not the price of fuel.
As an individual investor, our business plan should be to build wealth by buying companies we think will succeed. If we were to purchase hedges on companies or industries we own, it would be like Chevron (NYSE:CVX) making side-bets on the failure of the oil and gas industry. It just doesn't make sense.
Huang, Jing-Zhi, and Ying Wang. "Should Investors Invest in Hedge Fund-Like Mutual Funds? Evidence from the 2007 Financial Crisis." Journal of Financial Intermediation. (2010): n. page. Web. 24 Jan. 2013. <papers.ssrn.com/sol3/papers.cfm?abstract_id=1530242
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.