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 to pursue that. In a long-short equity approach, the investor takes a mix of long and short positions, hoping to create a portfolio that is balanced to take advantage of both rises and falls in the market.
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?
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.
Maximize the Spread
The other major goal of a long-short position is to maximize “the spread.” This is the difference between the long positions an investor has taken and their short positions. Ideally, investing this way allows an investor to gain on both growth and losses, creating more room for profit than by just investing for growth alone.
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.
In the first, 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
Overall, you have a portfolio worth $1 million with a 70/30 split between long assets and short. This is a long-short portfolio with what is known as a “long bias.” Your ideal goal is for shares of Company D and E to decline in value while the shares of Companies A, B and C go up. This would maximize your overall profits. If every company does well, your portfolio will generally profit due to its long bias, even though you’ll lose money on your investments in Company D and Company E.
If the market declines overall you will lose money due to this portfolio’s long bias. However, your investments in Company D and Company E means that 30 percent of your portfolio will profit during a downturn, mitigating your 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 a 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
While long-short investing is typically employed by major funds, you can use it to diversify your own portfolio as well. But first, a warning: Short positions are extremely risky for the average investor. While a stock can go no lower than zero, there’s theoretically no upper boundary for how high its price can climb. This means that unlike a long position, a short position has potentially unlimited losses. If the investment goes wrong it is possible to lose more money than you initially invested and end up in debt to your broker. So, if your short position is failing, consider closing it out before your losses pile up.
With that caution in mind, as an investor you can also use a short position hedge against market-wide risk. By adding a limited amount of short exposure to your portfolio, based on companies or industries you believe to be overvalued, you can create a segment of your portfolio that will ideally do well overall, but which is specifically tailored to profit in the case of market-wide losses.
Just do so with care.
The Bottom Line
Long-short investing is a diversification strategy that involves taking both long and short positions in the same portfolio. It allows you to hedge against systematic risk by investing in stocks that will profit even during a market-wide decline.
- Consider talking to a financial advisor about how long-short investing could boost your total returns. Finding the right financial advisor who fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
- If you’d like more information on what it means to take a long or a short position, check out this explainer. And if you’re wondering how much your portfolio needs to grow to achieve a given goal, use this helpful calculator to find out.
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