Investing 201: Investment Strategies and Hedging Tools
This is the third post in a series of posts I am going to write about investing. Each post will make most sense if you have read the ones before in sequence.
As discussed earlier, conventional investing primarily comprises of stocks and bonds, which we covered in Part 2. In this post, I want to touch upon a few tools: Leverage, short-selling, and hedging, which while not necessarily only applicable to stocks or bonds (they can apply to commodities, real estate, and other assets as well), are often used with these assets. They are not in common use because they 1) are higher risk and potentially higher reward, and 2) are more complicated to understand for most investors. These tools are heavily deployed by hedge funds, but not by mutual funds and most common investors for the reasons stated above.
I do not necessarily recommend using these tools unless you really know what you are doing and do not mind high risk. In fact, for the purpose of this post I will not discuss options or futures, but just know that they are an important part of investment universe, though one can somewhat replicate them using conventional investing.
Before we get on with the main topic, I wanted to rehash a few investment strategies that we already discussed in the last post (value investing, growth investing, contrarian investing, and momentum investing), with a slightly different lens — partly to address a few questions I received after my first two posts.
One consistent theme you should know is that these strategies are not mutually exclusive, and associated attributes are not always fixed. In other words, these are broad generalizations that should be taken with a pinch of salt.
Win big or win often — you can’t do both
Certain strategies favor winning big, which essentially implies you may lose often but lose small. Venture capital is a good example: Out of their ten investments, they hope one or two will give them a home run, two to three may break even, and five or more will be duds. If a fund invests $1 million in ten startups each, and five of those startups go bust, but one makes it a 50x, the fund has already made 5x as a whole.
Growth investing and momentum investing also generally align well with winning big. With growth investing you are hoping to make it big with the next “big thing”, and wouldn’t mind many (small) losses.
Conversely, contrarian and value investors typically go for winning often, but each win is a small win. This in turn implies that when they lose, they can lose big — but they don’t lose often.
As an exercise, can you figure out why contrarian is more akin to value investing?
Why can’t you win often and wing big too? Because, if you could do both, everyone would jump in too, thus driving up the costs and making wins smaller¹.
Where do these strategies fall on the risk spectrum?
This one is hard to answer, and once again, these generalizations do not always hold true. Some would argue that value investors are risk averse — they are not “betting” on the next big thing as growth investors are. But you could also make the opposite argument. Let’s see how.
Value investing is more contrarian than momentum: Contrarian investors typically get out when market is too hot and get in when everyone else is scared and valuation are going down. When seen from this lens, a contrarian investors are more of risk takers than risk averse.
I’d like to minimize the notion of bets, since there is an infinite debate to be had on speculation vs investing or hedging. That said, when I feel I am more on the “betting” side of the spectrum, I like to pick bets that are asymmetric: If I lose, I lose little, if I win, I win really big. One such bet (and this is not a recommendation) could be the infamous bitcoin. There are very strong arguments in favor as well as against bitcoin becoming “virtual gold” at some point. If that happens, the value of a bit coin could reach $600,000 but if it doesn’t, the value could drop significantly from today’s price of around $37,0000. In other words, in a worst case scenario, you may lose $37,000, but if you hold a bitcoin for long, you may get a nice 15x return!
As a simple example, let’s say you buy a stock for $200, but only have $100 to pay for it. You get a loan of $100 and buy the stock. The stock doubles to $400 — now you have made 300% of your original investment (minus any interest you owe on your $100 loan). If you did not use leverage, you would have made 200%. On the flip side, if the stocks falls below to $100, you will have wiped out your money (the stock is worth $100, but you owe $100, plus any interest). Leverage magnifies your gains but also losses.
To me leverage in itself is not interesting, however many hedging strategies require leverage. One that I want to focus on is short-selling: You essentially borrow a share (not money), and sell it at the market price, say $200. If the share value drops to $100, you can buy a share from the market, and pay back the share you owed. In the process you have made $100, minus any interest. Of course if value of the share increased, you will have lost money, and may face margin calls (which we will not get into). Note that as opposed to longing shares — whereby, the upside is infinite, but downside is limited, in short-selling the reverse is true: The downside is unlimited, but the upside is limited.
Moreover, short-selling carries a social stigma² — you are betting against an asset (be it real estate as in the financial crisis of 2007–08, or pound sterling leading up to Black Wednesday). Without getting into a philosophical debate though, short-sellers do keep markets in check (imagine if you did not have any short-sellers; the bubble could get even frothier), and hedge funds (which are not using just short-selling but many other tools as well) provide much needed liquidity³.
Hedging, as opposed to common understanding, does not necessarily mean that you are reducing your expected returns (while reducing your losses too). When played right, hedging can boost returns at a lower risk, as we will shortly see in an example. In general, hedge funds go for a few big wins, and do not mind a lot of small losses. Also, their goal is to return positive returns even in a down market, as opposed to beating a benchmark — this could however often mean they tend to outperform markets in a down market, but may under-perform in an up market. But they are in demand because investors like consistency — year in and year out they want positive returns regardless of how markets at large are behaving.
Let’s start with two portfolios: Portfolio A by a “traditional” investor, and Portfolio B by a “hedging” investor. Both start with $40,000 cash, but B can borrow $40,000 in her margin account. Now, let’s assume, A buys $20,000 of Tesla, and $20,000 of Apple stock. B, on the other hand buys $56,000 of Apple, and short-sells $24,000 of Tesla stock. Note that A’s net exposure to the market is $40,000, while B’s is $32,000 ($56,000 — $24,000). Let’s walk through a few scenarios.
You yourself can easily construct many other scenarios as well. The key for a hedging investor like any other investor is to pick good long stocks (and pick “good” short stocks). But she does not need both “bets” (Apple increasing in value, and Tesla decreasing in value) to hold true for her to make money — as long as Apple does better relative to Tesla (and that could mean that both stocks decrease in value, but Tesla falls sharper), she makes money.
As an exercise, can you work out a scenario where both stocks fall (but Tesla falls more), and can you see how “hedging” has reduced the market risk⁴?
A sneak peak into what’s coming next in the series.
Part 4: A simple value investing framework. I will walk through a simplified example of what evaluation of value stocks looks like.
Part 5: Alternative investments. This is a huge universe, and each of the asset classes can warrant a post — but we will touch upon a few important asset classes and themes.
Part 6: Real-estate. Some classify it in conventional and others in alternate investing. It is big and important enough of an asset class to warrant a separate post. While I arguably know the least about real-estate (compared with most other popular asset classes), I hope to talk about a few interesting aspects.
Part 7: Private equity. This one is perhaps closest to home. I will discuss angel investing, venture capital (note though that in all my posts I am wearing hat of an individual rather than an institutional investor), and pre IPOs — but not the traditional private equity (which largely entails a PE firm taking a public company private — doing financial engineering, reorganization, and other fine tuning, and selling it off at huge gains).
I will conclude by summing up, but also shed light on overall portfolio management.
¹ This gels well with efficient market hypothesis, which at its extreme stipulates that there is no free lunch. But of course markets are inefficient before they are efficient, and there is always an opportunity to be found there. It is just generally hard however.
² Personally speaking, I do not have any qualms about short-selling, but neither am I a proponent of it — not withstanding the recent GameStop saga, where a few folks stood up to large hedge funds that were shorting the stock, and thus causing what we call “short squeeze” — in order to cover their losses, short-sellers are forced to buy shares, and in result end up increasing the price, ironically.
³ Some experts argue that hedge funds tend to replicate behavior of momentum investing — buy high, sell low — and thus drive up the liquidity need rather than reducing it. While interesting, this is too simplistic an observation.
⁴ While I did not show it in this example, hedging or leverage can also allow an investor to reduce stocks selection risk vis-à-vis diversification.
As an exercise, could you see why?