For both retail and professional investors alike, most portfolios should strike a balance between risk mitigation and profit-seeking. Long-short equity investing is one strategy that many large-scale investors use. In a long-short equity approach, the investor takes a mix of long and short positions, hoping to create a portfolio that’s balanced to take advantage of both rises and falls in the market. A financial advisor can help you understand if the long-short equity strategy makes sense for your portfolio.
How Long-Short Equity Investing Works
A long-short equity position is a strategy used mainly by large firms such as hedge funds or mutual funds. It involves investing in stocks (otherwise known as “equities”), but it mirrors similar practices used often by options and futures traders.
In this trading scheme, the investor takes a combination of long and short positions in a single portfolio. They take long positions (buying shares to profit off price gains) in stocks that they believe are undervalued and poised for growth. They take short positions (borrowing shares to sell and profit off price decreases) in stocks they believe are overvalued and poised to decline.
The result is a mixed portfolio. Most long-short strategies emphasize the long position, often taking a 70/30 mixture of long vs. short positions. This is not necessary, however, and a particularly pessimistic investor could even emphasize short positions if they felt that was wise. Due to the market’s general upward trend in recent years, long-short portfolios that emphasize short positions are quite rare.
Many long-short portfolios will emphasize particular markets or geographic areas. For example, an investor could build their portfolio around a specific sector, like technology or retail firms.
Why Take a Long-Short Equity Position?
You can take a long-short position in your portfolio in order to hedge against other investments in your strategy. Here are the three main reasons or strategies that could drive you to use this type of position.
1. Mitigate Systematic Risk
The main reason why funds take a long-short equity position is to insulate themselves against marketwide exposure. If the market as a whole gains value, as it typically does, a portfolio that emphasizes long positions will profit. (Although the investor hopes to have nevertheless correctly identified overvalued stocks.) However, if the stock market declines overall, the portfolio’s short positions will partially insulate it from losses.
2. Maximize the Spread
Another key objective of a long-short strategy is to maximize “the spread.” That’s the difference between an investor’s long and short positions. This approach aims to capture gains from both rising and falling assets, potentially increasing profit opportunities beyond those available through growth-focused investments alone.
3. Market Neutral Positions
A less common goal for long-short equity is to build what is called a “market-neutral position.” In this case, the investor will have invested the same amount of money in short positions as in long ones. The goal of this position is to insulate the portfolio from the market altogether, taking equal losses and gains from overall market trends up or down.
Example of Long-Short Investing
Let’s consider two sample portfolios to see this concept in practice. For the first sample let’s say you build a long-short portfolio designed to grow but mitigate risk overall. To do this, you might select five stocks and build a portfolio along the following lines:
- Company A – Long position, $250,000
- Company B – Long position, $250,000
- Company C – Long position, $200,000
- Company D – Short position, $150,000
- Company E – Short position, $150,000
Your portfolio would be valued at $1 million, allocated in a 70/30 split between long and short positions, respectively. This structure represents a “long bias” in a long-short portfolio. Ideally, your strategy would aim for the shares of Companies D and E to decrease in value while those of Companies A, B and C appreciate, maximizing overall profits. If all companies perform well, the portfolio’s long bias means you’ll likely see gains, even though your positions in Companies D and E may incur some losses.
However, if the market experiences a downturn, the portfolio’s long bias would typically result in losses. Yet, the 30% allocation to short positions in Companies D and E would generate profits during this decline, helping to offset some of the losses.
Now let’s consider a market-neutral portfolio.
In this, you invest in four companies:
- Firm A – Long position, $250,000
- Firm B – Long position, $250,000
- Firm C – Short position, $250,000
- Firm D – Short position, $250,000
This is a market-neutral portfolio. If the market as whole gains 10 percent in value, you will gain $25,000 in profit from your investments in Firm A and Firm B and lose $25,000 from your investments in Firm C and Firm D. If the market as a whole falls by 10 percent, you will gain $25,000 in profit from Firms C and D even while your shares in Firms A and B lose the same. The goal of this portfolio is to profit off its specific investments, with Firm A and Firm B gaining value while share prices decline for Firm C and Firm D.
Long-Short Investing and You
Long-short investing is a strategy often utilized by major funds, but individual investors can also leverage it to diversify their portfolios. However, a word of caution: Short positions carry significant risk, especially for the average investor. While a stock’s price can’t drop below zero, there’s no theoretical limit to how high it can rise. This means that, unlike a long position, a short position can lead to unlimited losses. If the trade goes against you, it’s possible to lose more than your initial investment and end up owing your broker. So if your short position isn’t performing well, consider closing it to prevent escalating losses.
That said, with prudent risk management, a short position can serve as a hedge against broader market risk. By adding a limited amount of short exposure to your portfolio – targeting companies or sectors you believe to be overvalued – you can create a balanced strategy. This approach aims to generate positive overall returns while providing a potential safeguard in case of market downturns.
Bottom Line
Long-short investing is a diversification strategy that involves taking both long and short positions in the same portfolio over a period of time. It allows you to hedge against systematic risk by investing in stocks that will profit even during a market-wide decline. This may not be a strong investment strategy for everyone which is why it is important to work with an advisor who can advise on your unique financial goals.
Investing Tips
- Consider talking to a financial advisor about how long-short investing could boost your total returns. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you’re wondering how much your portfolio needs to grow to achieve a given goal, use this helpful investment calculator to find out.
Photo credit: ©iStock.com/Mlenny, ©iStock.com/katleho Seisa, ©iStock.com/tunart