Hedging is taking an offsetting position to reduce the risk of an existing exposure. Long a stock and worried about a downturn? Buy a put option, short a correlated index, or short a related ETF. The goal isn't to neutralize all risk — it's to cap the worst case.
Hedging is never free. Options premium, short-stock borrow costs, and the bid-ask spread on the hedge instrument all eat into your expected return. A perfectly hedged portfolio earns the risk-free rate by definition — anything you earn above that comes from leaving some risk on the table.
The right mental model: hedging is insurance, not a feel-safer button. Insurance has a positive expected cost in normal times (you pay the premium and nothing happens) and a large negative cost avoided in tail scenarios (your house burns down and you're not bankrupt). Use it the same way: hedge against the tail events you can't tolerate, accept the running premium drag, don't hedge to feel comfortable about positions that are just normal-sized.
Common retail mistakes: over-hedging during obvious selloffs (locking in losses at exactly the wrong time), using costly out-of-the-money puts as 'cheap insurance' that almost always expire worthless, and confusing 'hedged' positions with 'safe' positions when the correlation between the asset and the hedge breaks down in a real crisis (see: 2008, when nearly every cross-asset correlation went to 1).