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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.