What is the difference between hedging and diversification? How does each reduce risk?
Hedging - You have an investment and are worried that the price might drop in the near future. You don't want to sell as this will realise a capital gain for which you may have to pay capital gains tax. So instead you make an investment in another instrument (sometimes called insurance) to offset falls in your investment.  An example may be that you own shares in XYZ. You feel the price has risen sharply over the last month and is due for a steep fall. So you buy some put option over XYZ. You pay a small premium and if the price of XYZ falls you will lose money on the shares but will make money on the put option, thus limiting your losses. If the price continues to go up you will only lose the premium you paid for the option (very similar to an insurance policy). Diversification - This is when you may have say $100,000 to invest and spread your investments over a portfolio of shares, some units in a property fund and some bonds. So you are spreading your risks and returns over a range of products. The idea is if one stock or one sector goes down, you will not lose a large portion of your investment, as it is unlikely that all the different sectors will all go down at the same time. "The difference is in the interrelation between the varied investments you make. Hedging is about specifically offsetting a possible loss in an investment by making another related investment that will increase in value for the same reasons that the original investment would lose value. Gold, for instance, is often regarded as the ultimate hedge. Its value is typically inversely correlated to the rest of the market as a whole, because its status as a material, durable store of value makes it a preferred ""safe haven"" to move money into in times of economic downturn, when stock prices, bond yields and similar investments are losing value. That specific behavior makes investing in gold alongside stocks and bonds a ""hedge""; the increase in value of gold as stock prices and bond yields fall limits losses in those other areas. Investment of cash in gold is also specifically a hedge against currency inflation; paper money, account balances, and even debt instruments like bonds and CDs can lose real value over time in a ""hot"" economy where there's more money than things to buy with it. By keeping a store of value in something other than currency, the price of that good will rise as the currencies used to buy it decrease in real value, maintaining your level of real wealth. Other hedges are more localized. One might, for example, trade oil futures as a hedge on a position in transportation stocks; when oil prices rise, trucking and airline companies suffer in the short term as their margins get squeezed due to fuel costs. Currency futures are another popular hedge; a company in international business will often trade options on the currencies of the companies it does business in, to limit the ""jitters"" seen in the FOREX spot market caused by speculation and other transient changes in market demand. Diversification, by contrast, is about choosing multiple unrelated investments, the idea being to limit losses due to a localized change in the market. Companies' stocks gain and lose value every day, and those companies can also go out of business without bringing the entire economy to its knees. By spreading your wealth among investments in multiple industries and companies of various sizes and global locations, you insulate yourself against the risk that any one of them will fail.  If, tomorrow, Kroger grocery stores went bankrupt and shuttered all its stores, people in the regions it serves might be inconvenienced, but the market as a whole will move on. You, however, would have lost everything if you'd bet your retirement on that one stock. Nobody does that in the real world; instead, you put some of your money in Kroger, some in Microsoft, some in Home Depot, some in ALCOA, some in PG&E, etc etc. By investing in stocks that would be more or less unaffected by a downturn in another, if Kroger went bankrupt tomorrow you would still have, say, 95% of your investment next egg still alive, well and continuing to pay you dividends. The flip side is that if tomorrow, Kroger announced an exclusive deal with the Girl Scouts to sell their cookies, making them the only place in the country you can get them, you would miss out on the full possible amount of gains you'd get from the price spike if you had bet everything on Kroger.  Hindsight's always 20/20; I could have spent some beer money to buy Bitcoins when they were changing hands for pennies apiece, and I'd be a multi-millionaire right now. You can't think that way when investing, because it's ""survivor bias""; you see the successes topping the index charts, not the failures. You could just as easily have invested in any of the hundreds of Internet startups that don't last a year."
"I think you're confusing risk analysis (that is what you quoted as ""Taleb Distribution"") with arguments against taking risks altogether. You need to understand that not taking a risk - is by itself a risk. You can lose money by not investing it, because of the very same Taleb Distribution: an unpredictable catastrophic event. Take an example of keeping cash in your house and not investing it anywhere. In the 1998 default of the Russian Federation, people lost money by not investing it. Why? Because had they invested the money - they would have the investments/properties, but since they only had cash - it became worthless overnight. There's no argument for or against investing on its own. The arguments are always related to the investment goals and the risk analysis. You're looking for something that doesn't exist." Colloquially, there's no difference except for the level of risk (which is an estimate anyway). Classically, investment is creating wealth through improvement or production.  Purchasing a house with the intent to renovate and sell it for a profit would be an investment, as the house is worth more when you sell than when you bought it. Speculation, on the other hand, is when you hope to make a profit through changes in the market itself.  Purchasing a house, letting it sit for 6 months, and selling it for a profit would be speculation. It has been hinted at in some other answers, but I want to say it explicitly: Volatility is not risk. Volatility is how much an investment goes up and down, risk is the chance that you will lose money. For example, stocks have relatively high volatility, but the risk that you will lose money over a 40 year period is virtually zero (in particular if you invest in index funds). Bonds, on the other hand, have basically no volatility (their cash flow is totally predictable if you trust the future of your government), but there is a significant risk that they will perform worse than stocks over a longer period. So, volatility equals risk only if you are day trading. A 401(k) is literally the opposite of that. For further reading: Never confuse risk and volatility Also, investing is not gambling. Gambling is bad because the odds are stacked against you. You need more than average luck to actually win and the longer you play, the more you will lose. Investing means buying productive capital that will produce further value. The odds are in your favor. Even if you do a moderately bad job at investing, the longer you stay, the more you will win. "The calculation and theory are explained in the other answers, but it should be pointed out that the video is the equivalent of watching a magic trick.  The secret is: ""Stock A and B are perfectly negatively correlated.""  The video glasses over that fact that without that fact the risk doesn't drop to zero. The rule is that true diversification does decrease risk. That is why you are advised to spread year investments across small-cap, large-cap, bonds, international, commodities, real estate. Getting two S&P 500 indexes isn't diversification.  Your mix of investments will still have risk, because return and risk are backward calculations, not a guarantee of future performance. Changes that were not anticipated will change future performance. What kind of changes: technology, outsourcing, currency, political, scandal." "When you invest in a single index/security, you are completely exposed to the risk of that security. Diversification means spreading the investments so the losses on one side can be compensated by the gains on the other side. What you are talking about is one thing called ""risk apettite"", more formally known as Risk Tolerance: Risk tolerance is the degree of variability in investment returns that an investor is willing to withstand. (emphasis added) This means that you are willing to accept some losses in order to get a potential bigger return. Fidelity has this graph:  As you can see in the table above, the higher the risk tolerance, the bigger the difference between the best and worst values. That is the variability. The right-most pie can be one example of an agressive diversified portfolio. But this does not mean you should go and buy exactly that security compostion. High-risk means playing with fire. Unless you are a professional stuntman, playing with fire usually leaves people burnt. In a financial context this usually means the money is gone. Recommended Reading: Investopedia; Risk and Diversification: The Risk-Reward Tradeoff Investopedia; How to construct a High Risk portfolio Fidelity: Guide to Diversification KPMG: Understanding and articulating Risk Appetite (pdf)" "I though that only some hedge funds operated that way and others were specific vehicles to provide an efficient hedge? This one is described as ""betting against chipmakers"" and is blaming a substantial loss against one market, so it can't be doing a great job of hedging itself.   Though I think we're saying the same thing and just have a different view of the common meaning of ""hedge fund""." Sometimes hedging is used if you have a position and you feel the market is going against your position, so one would hedge that position in order to protect their capital and possible profits instead of closing the position and incurring capital gains tax. Personally if the market was going against a position I had open I would get out of that position and protect my capital/profits instead of using more capital to hedge against my position. I would rather take a profit and pay some capital gains tax than watch my profits turn into a loss or use up more capital to try and protect a bad position. Hedging can be useful in certain circumstances but I think if you feel the market is going against your position/s for the medium to long term you should just get out of your positions instead of hedging against them. "I think that the answer by @jkuz is good.  I'd add that the there's a mathematically precise difference:  Gambling games are typically ""zero-sum"" games, which means that every dollar won by one person is lost by another. (If there's a ""house"" taking a cut then it's worse than zero-sum, but let's ignore that for the moment.)   None of the markets that you mentioned are zero-sum because it's possible for both parties in the transaction to ""win"" since they typically have different objectives.  If I buy stock, I typically desire for it to go up to make money, but, if I sell stock, I typically sell it because I want the money to do something else completely.  The ""something else"" might be invest in another instrument if I think it's better or I'm rebalancing risk.  It might also be to buy a house, pay for college, or (if I'm in retirement living on my investments) to buy food.  If the stock goes up, the buyer won (increased investment) but the seller also won (got the ""other thing"" that they wanted/needed), which they would not have been able to get had there not been a buyer willing to pay cash for the stock. Of course it's possible that in some cases not everyone wins because there is risk, but risk should not be considered synonymous with gambling because there's varying degrees of risk in everything you do." The point of derivatives is to get rid of the risk you don't want so you can acquire exposure only to the risk you want. Who wants weather/temperature risk -- speculators. Who doesn't want that risk? Anyone who's core business is adversely affected by bad weather. It's the same reason multinational firms will hedge FX and interest rates. All a speculator is typically doing is taking the other side of the trade based on what they feel is the true price of the risk they are assuming Delta hedging is not the same as being delta neutral, what you just described is being delta neutral. There exist reasons for a retail trader to be conscious of delta when choosing an option. You are diversified within a particular type of security. Notably the stock market. A truly diversified portfolio not only has multiple types of holdings within a single type of security (what your broad market fund does) but between different types. You have partially succeeded in doing this with the international fund - that way your risk is spread between domestic and international stocks. But there are other holdings. Cash, bonds, commodities, real estate, etc. There are broad index funds/ETFs for those as well, which may reduce your risk when the stock market as a whole tanks - which it does on occasion. I consider speculation to be a security purchase where the point is to sell it to someone for a higher price.  Day-trading is completely speculative. I consider Investment to be a purchase you make for its underlying value. You are buying it at that price because you believe the present value of the future payments is higher than the price you are paying. I may sell an investment if a higher price is offered than I think it's worth, or if the business situation changes, but I don't plan on it.   Hedging is a third type of security purchase, where you are decreasing your overall risk.  If you are a hog farmer, selling hog futures on the CME is hedging, because it locks in the amount you get per hog, regardless of what the price of hogs does. Commodities markets only have hedgers and speculators.  Investors don't make sense, it doesn't have an underlying value. "The risk of any investment is measured by its incremental effect on the volatility of your overall personal wealth, including your other investments.  The usual example is that adding a volatile stock to your portfolio may actually reduce the risk of your portfolio if it is negatively correlated with the other stuff in your portfolio. Common measures of risk, such as beta, assume that you have whole-market diversified portfolio. In the case of an investment that may or may not be hedged against currency movements, we can't say whether the hedge adds or removes risk for you without knowing what else is in your portfolio.  If you are an EU citizen with nominally delimited savings or otherwise stand to lose buying power if the Euro depreciates relative to the dollar, than the ""hedged"" ETF is less risky than the ""unhedged"" version.  On the other hand, if your background risk is such that you benefit from that depreciation, then the reverse is true. ""Hedging"" means reducing the risk already present in your portfolio.  In this case it does not refer to reducing the individual volatility of the ETF.  It may or may not do that but individual asset volatility and risk are two very different things." Basically, diversifying narrows the spread of possible results, raising  the center of the returns bell-curve by reducing the likelihood of extreme results at either the high or low end.  It's largely a matter of basic statistics. Bet double-or-nothing on a single coin flip, and those are the only possible results, and your odds of a disaster (losing most or all of the money) are 50%. Bet half of it on each of two coin flips, and your odds of losing are reduced to 25% at the cost of reducing your odds of winning to 25%, with 50% odds that you retain your money and can try the game again. Three coins divides the space further; the extremes are reduced to 12.5% each, with the middle being most likely. If that was all there was, this would be a zero-sum game and pure gambling. But the stock market is actually positive-sum, since companies are delivering part of their profits to their stockholder owners. This moves the center of the bell curve up a bit from break-even, historically to about +8%. This is why index funds produce a profit with very little active decision; they treat the variation as mostly random (which seems to work statistically) and just try to capture average results of a (hopefully) slightly above-average bucket of stocks and/or bonds. This approach is boring. It will never double your money overnight. On the other hand, it will never wipe you out overnight. If you have patience and are willing to let compound interest work for you, and trust that most market swings regress to the mean in the long run, it quietly builds your savings while not driving you crazy worrying about it. If all you are looking for is better return than the banks, and you have a reasonable amount of time before you need to pull the funds out, it's one of the more reliably predictable risk/reward trade-off points. You may want to refine this by biasing the mix of what you're holding. The simplest adjustment is how much you keep in each of several major investment categories. Large cap stocks, small cap stocks, bonds, and real estate (in the form of REITs) each have different baseline risk/return curves, and move in different ways in response to news, so maintaining a selected ratio between these buckets and adding the resulting curves together is one simple way to make fairly predictable adjustments to the width (and centerline) of the total bell curve. If you think you can do better than this, go for it. But index funds have been outperforming professionally managed funds (after the management fees are accounted for), and unless you are interested in spending a lot of time researching and playing with your money the odds of your doing much better aren't great unless you're willing to risk doing much worse. For me, boring is good. I want my savings to work for me rather than the other way around, and I don't consider the market at all interesting as a game. Others will feel differently. "It's interesting that you use so many different risk measures. Here's what I'd like to know more in detail:  1) About the use of VaR. I've heard (from a friend, may be unreliable) that some investment managers like Neuberger Berman doesn't use VaR for assessing risk and maintaining capital adequacy requirements. Rather, some firms only rely on tracking error, beta, standard deviation, etc. Why do you think is this so? Isn't VaR supposed to be a widely accepted risk measure.  2) The whole ""Expected Shortfall vs. VaR"" debate. I've read some papers comparing Expected Shortfall and VaR. Mainly, they criticize VaR for not being able to consider the 1% probability left where losses can (probably) skyrocket to infinity. If I need to choose between the two, which do you think is better and why?"