Stocks go up. Stocks go down.
When they’re wrong – and at some point, they’re always wrong – they get worried and distressed. Sometimes, they lose huge amounts of money. It ruins retirements and major plans for the future.
This makes no sense. Why prepare for just one thing, when two things – only two things – always happen?
Today, I’m asking you to recalibrate how you think about stocks.
This is a big “ask”… And it won’t be easy.
But once you understand the benefits of this way of thinking – and especially once you begin to practice it – you’ll likely never invest in stocks the same way again.
In my DailyWealth Trader (DWT) service, I routinely cover some of the best ways to reduce your investing risk.
I call one of them “market-neutral thinking.”
Many of you have heard of market-neutral strategies before. “Pairs trading” is one example…
In a pairs trade, you sell one asset short (bet that it will go down) and buy another asset (bet that it will go up). You do this in equal dollar amounts.
A pairs trade is “market neutral” because its profitability doesn’t depend on the direction of the market. It only depends on one asset outperforming the other asset.
Market-neutral thinking is based on the same idea… But it goes a bit further.
Here’s how it works…
Imagine selling all of your stocks right now. In their place, you have cash. (Cash is market neutral.)
Now, pretend you have no guesses about where the stock market is headed. You know nothing about geopolitics… nothing about the global debt levels or the Federal Reserve… nothing even about the historical uptrend in stocks.
You only know that some stocks do better than the market as a whole… And some stocks do worse. But for the most part, good stocks and bad stocks will all move in the direction of the broad market.
So you have your cash pile… And you don’t have a clue where stocks are headed. How do you invest?
The most logical strategy would be to try to identify stocks that will outperform the market… and buy those. Then try to identify stocks that will underperform the market… and sell those short.
Again, you would do each in equal dollar amounts. This way, it doesn’t matter if the stock market goes up or down. Your portfolio will be profitable if, on average, the stocks you bought outperform the stocks you sold short.
This is a market-neutral portfolio. And if you have no idea where the stock market is going, this is how you should invest.
Now, let’s take the next step…
Let’s say you think the market will go up over the next six months… But you’re not too confident. Maybe you’re 30% sure.
It’s far wiser to be unsure and well prepared to be wrong than it is to be overly confident and totally unprepared.
So what do you do?
Let’s say you want $100,000 of your net worth allocated to stocks. You can simply buy stocks with $30,000 (30%) and hold the rest in cash.
Or, you can buy stocks with $60,000 and sell $30,000 worth of stocks short. This way, only 30% ($30,000) of your portfolio depends on the market rising for you to profit. The rest – $30,000 long, $30,000 short, and your cash – is market neutral. If you choose your longs and shorts well, you’ll profit no matter what happens in the market.
The same is true if you buy $100,000 worth of stocks and sell $70,000 short. Again, you have a 30% “net long” portfolio. This is a good way to express 30% confidence that the market will rise.
If you’re 30% sure the market is going to drop, you can do the opposite…
You can sell $30,000 worth of stocks short and hold the rest in cash. You can sell $60,000 worth of stocks short and hold $30,000 worth of stocks long. Or you can sell $100,000 worth of stocks short and hold $70,000 worth of stocks long. These are all 30% “net short” portfolios. And again, they’re all 70% market neutral.
Thinking and investing like this comes with all kinds of benefits…
I’ll start with the financial. Let’s say we’re in a big bull market. Stocks are in a strong uptrend… And you’re long with 100% of your stock allocation ($100,000). No short positions. No cash.
You’re doing amazingly well… For five straight years, you make 20% annual returns.
That’s Portfolio 1.
In Portfolio 2, you’re also confident the bull market will continue. But instead of going long with 100% of your portfolio, you decide to hold a 70% net long position. You hold $100,000 worth of stocks long. And you short $30,000 worth of stocks.
Like Portfolio 1, your long positions are exceptional. They generate 20% annual returns. Your short positions, on average, lose money. You chose them well… So they don’t lose as much as your long positions made. But they generate 10% annual losses.
At the end of each year, you move some things around so you’re again 70% net long (100% long, 30% short). Each year for five years, your longs generate 20% annual returns and your shorts lose 10%.
In year six, the stock market drops 50%…
Stocks go up. Stocks go down.
Your stocks match the percentage move of the overall market in year six. Your longs drop 50%. Your shorts (if you have any) rise 50%. Which portfolio do you think is better off at the end of year six?
Let’s take a look…
In the table below, you can see where each portfolio stands at the end of each year. On the right-hand side of the table, you can see the annual dollar returns of Portfolio 2’s 30% short position.
You can see that as Portfolio 2 grows, the losses it endures from holding a 30% short position grow, too. By year five, Portfolio 1 is nearly $30,000 ahead of Portfolio 2. That’s 30% on the original investment.
But in year six, the short position pays off. It generates a $32,887 profit… putting Portfolio 2 ahead of Portfolio 1 for the entire six-year period.
This is a simplified example. When you’re using market-neutral thinking, you can do much better than the table above suggests…
If you are convinced you’re in the early stages of a big bull market, you may choose not to hold any short positions. And if you’re convinced a bull market is coming to an end, you can increase your short positions. Maybe you go 100% market neutral… or even net short, once the trend turns down.
Market-neutral thinking and investing also has tremendous psychological benefits…
When your portfolio is 100% long, you’ll likely see red (from losses) on every single one of your positions – day after day – during a bear market. Your stress levels will be off the charts. And you’ll likely make bad decisions… like selling near the bottom.
But if you’re, say, 50% market neutral during a bear market, you’ll see lots of your positions increase in value while stocks are dropping. You’ll still lose money. But you’ll lose less.
It eases the pain. You were expecting this. You were prepared.
All it takes is a shift in how you approach stocks. Remember… They go up and down. That’s it.
Be ready for both.
Source: Daily Wealth