In a period of time in which stock prices have continued to climb to higher and higher valuation multiples, many investors are doing what they can to minimize downside risk and maximize overall long-term returns.
Investing in precious metals, commodities or other securities which are negatively correlated to equities is one way to hedge downside risk. In this article, I’m going to discuss another method which has been proven to be successful over long periods of time – long/short strategies.
The idea is that most investors (including myself) cannot correctly predict which direction the market will go with any relative certainty within a given time frame. The random walk theory speaks to the idea that the stock market moves in a random direction, but generally upward over time.
Picking tops and bottoms is a very dangerous game, and in that sense, investing becomes all the more difficult when the next recession may be right around the corner, yet it is unanticipated by the market in general.
To rid a portfolio of a significant amount of systematic risk (i.e. all stocks falling at once), a famous strategy employed by many stock pickers is a long/short strategy.
By taking a company one believes to be the strongest in its sector and purchasing a stake in said company, while simultaneously shorting the company believed to be the worst performer in the long-run in a given industry, an investor can absorb the value differential between the two firms, with the vast majority of market risk eliminated from the trade.
If the stock market increases, the stronger company should increase more than the weak company, generated a gain from the trade. If the market decreases, the short should decrease more than the long position, generating a gain.Invest Wisely, my friends.