For both retail và professional investors alike, most portfolgame ios should strike a balance between risk mitigation & profit seeking. Long-short equity investing is one strategy that many large-scale investors use khổng lồ pursue that. In a long-short equity approach, the investor takes a set of long & short positions, hoping khổng lồ create a portfolio that is balanced to take advantage of both rises and falls in the market.

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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 & short positions in a single portfolio. They take long positions (buying shares to lớn profit off price gains) in stocks that they believe sầu are undervalued và poised for growth. They take short positions (borrowing shares khổng lồ sell và profit off price decreases) in stocks they believe are overvalued và poised lớn decline.

The result is a mixed portfolio. Most long-short strategies emphakích cỡ 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 emphakích thước short positions if they felt that was wise. Due lớn the market’s general upward trend in recent years, long-short portfolios that emphakích thước short positions are quite rare.

Many long-short portfolquả táo will emphakích thước particular markets or geographic areas. For example, an investor could build their portfolio around a specific sector, lượt thích technology or retail firms.

Why Take A Long-Short Equity Position?

There are three main reasons lớn use this strategy.

Mitigate Systematic Risk

The main reason why funds take a long-short equity position is khổng lồ 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 khổng lồ have nevertheless correctly identified overvalued stocks.) However, if the stoông chồng 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 lớn 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 khổng lồ 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 lớn insulate the portfolio from the market altogether, taking equal losses & gains from overall market trends up or down.

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Example of Long-Short Investing

Let’s consider two sample portfolquả táo to see this concept in practice.

In the first, you build a long-short portfolio designed khổng lồ grow but mitigate risk overall. To vày this, you might select five sầu stocks & 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 sầu a portfolio worth $1 million with a 70/30 split between long assets & short. This is a long-short portfolio with what is known as a “long bias.” Your igiảm giá goal is for shares of Company D và E to lớn decline in value while the shares of Companies A, B & 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 thất bại money on your investments in Company D & Company E.

If the market declines overall you will đại bại 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 & Firm B & thất bại $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 & B thảm bại the same. The goal of this portfolio is to lớn profit off its specific investments, with Firm A & Firm B gaining value while cốt truyện prices decline for Firm C & Firm D.

Long-Short Investing And You

While long-short investing is typically employed by major funds, you can use it to lớn diversify your own portfolio as well. But first, a warning: Short positions are extremely risky for the average investor. While a stochồng 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 lớn đại bại more money than you initially invested and over up in debt to lớn 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 lớn your portfolio, based on companies or industries you believe khổng lồ be overvalued, you can create a segment of your portfolio that will ideally bởi vì well overall, but which is specifically tailored to lớn profit in the case of market-wide losses.

Just bởi vì so with care.

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The Bottom Line

Long-short investing is a diversification strategy that involves taking both long và short positions in the same portfolio. It allows you to lớn hedge against systematic risk by investing in stocks that will profit even during a market-wide decline.

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