Long/Short Helps Your Sanity
What is Long/Short?
‘Long/Short’, you must have heard it before. If you haven’t come cross this terminology or are unclear with its precise meaning, here is an attempt at explaining it. Long/Short investing is essentially the overlaying of short positions on top of long positions. In the case of equities, it means you have decided to long some stocks and to short-sell some stocks at the same time.
Shorting Opens Up The ‘Other Side’
Most directly, it provides you a way to get out of the ‘long-only’ box where you must only buy stocks. It enables the portfolio to pursue stocks that may go down in value. As the market is ultimately composed of stocks that go up as well as go down, having a Long/Short strategy opens up the other side of the universe, if you will.
Yes, investing in the rise or fall of a stock opens up opportunities. Imagine the ability to short the US housing market through banking stocks before its collapse. Imagine the ability to short tech stocks when the Dot-Com bubble blew up. Shorting offers a tremendous upside for the savvy cynics inside of all of us.
But It Does More Than That…
The more nuanced and powerful reason for having a Long/Short framework is to reduce the systematic risk component in any portfolio. Ok, that is a mouthful but what does it mean? Systematic risk is a fancy name the ‘market risk’ of a portfolio. It is when the broad market moves a single stock due to reasons outside the stock itself. It is the broad brash effect of the entire market on a stock. For example, your stock selection today can be perfect for a list of fundamental and technical reasons, but a devastating fall on the market will prompt sellers to hammer your healthy stock nonetheless. It has nothing to do with the stock, it is the market doing that!
The Long/Short strategy can help to reduce that market risk. When you have long positions and short positions at the same time, a fall on the market will benefit those stocks that you short, at the expense of your long positions. A rise in the market will benefit those stocks that you long, and produce a negative effect for those that you short. But on the net, regardless of market direction, you are going to benefit one way or the other. Of course, you also lose out on the other side. However, the idea is to strip away the market impact and leave the portfolio with the intrinsic qualities of the stocks.
Through the use of Long/Short, the manager or trader is getting rid of the systematic risk to refine for the true quality of the stock. At the end of the day, if the stock is bound to go up or down, it is going to do that regardless of market movements.
The All-Too-Important Psychological Dimension
What many investors do not appreciate or understand is the benefit of reduced volatility through Long/Short strategies. Long-only strategies where you can only buy stocks tend to create larger and longer drawdowns. More time is spent on losing and recovering the downturns in the portfolio. Days, weeks and even months may be necessary to recover an account from a period of drawdown. As time drags on, staying with the portfolio becomes exponentially more difficultly psychologically.
Do not underestimate the effect long drawdowns can have on the human mind. The more time it takes, the harder it is to believe in the investment process. ‘Long patience’ is easier said than done. Patience is a reflection of one’s ability to withstand the pain of being wrong in the short term while believing the strategy to be right in the longer term. It is an emotional, psychological and biologically challenging thing to pull off.
As a result, a manager, trader or an investor wants to reduce the time and depth of drawdowns if and when possible. This is the true reason for adopting a Long/Short strategy.
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