Limiting your Risk with Market-Neutral Investing

Market-neutral investing is an investment strategy that helps you manage risk. It offers protection against market volatility by utilizing simultaneous long (buying securities) and short (borrowing securities in order to sell them) market positions, or by using options or index funds as a hedge. Thus, a market-neutral portfolio would consist of long positions that would be expected to perform well if the market is strong and short positions that would profit if the market does poorly. The theory behind this strategy is that if the market does well you'll make money on your long position, and if it does poorly you'll make money from your short position; you therefore have some protection against loss either way the market moves. You don't know which way the market will go; but if you believe, for example, that there's a 70 percent chance of it going up, you might invest 70 percent of your portfolio into long positions and 30 percent into short positions. Or, because short selling can be extremely risky, as an alternative you could invest the 30 percent in defensive stocks such as food and beverage producers and pharmaceuticals that generally do well in any economy. You hedge both your positions so that whichever one is wrong, you have protection with the other. In other words, you're neutral to the market.

When using market-neutral investing, stock selections should be based on the state of the current economy. For example, during periods of low interest rates, construction and housing stocks traditionally do well. Therefore, most investors would typically take long positions in those stocks. However, a market-neutral investor would go a bit farther and look for stocks to short that would likely do poorly if the particular market turned sour, which in this instance might be brokerage stocks. Or he could possibly consider using options of stocks as a hedge, which might be less expensive and certainly less risky than short selling.

The market-neutral strategy can be applied to any investing style. A value investor, for example, might buy undervalued stocks and short stocks considered overvalued. A growth investor could buy high-growth stocks and short those with opposite traits. A momentum investor may buy stocks just beginning their upward movement and short stocks that have a downward momentum.

It must be remembered that the market-neutral strategy is not designed to speculate on the short side; the primary objective of the short position is not to make money but to help provide protection in the event of a market reversal. It is first and foremost a method of managing risk. As such, not only must you consider your long positions, you must also study your short or defensive positions very carefully. Each scenario must be evaluated closely to ensure that you've chosen the best possible combination of stocks. Because of this, market-neutral investing could potentially double the amount of time that you'd normally spend selecting stocks because you must eye both sides of the equation. You must be prepared to devote the time and energy necessary to do it correctly.

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