Winning By Losing

One aspect of markets is their inherent nature of going both up and down for extended periods of time. If you look at history, you can see where markets from high valuations have taken in some cases 20 years to return to their previous high in real terms (don’t be fooled by nominal returns which are eaten away by high inflation - which I think we are heading for). 

The obvious response is to generate returns we normally only invest in what the industry calls “long only”. That is, you want to stock market to rise. Going “short” means you want the stock market to fall. 

As I have previously mentioned, volatility is just the change in price over a specific period of time. Portfolios that outperform are seeking positive returns with less volatility. The reason why is based on the mathematics of price changes. Impacts from price declines are more than the gains from price rises. This is why we focus on the geometric average return not the arithmetic average return. 

However, can you grow your portfolio from shorting? Most investors look at shorting in isolation, ie. did I make money on just my short portfolio, whereas it is more appropriate to look at the portfolio as a whole and the impact shorting has over time. 

What we know is you can actually make more profits from having a short position and rebalancing between your long and short portfolio. This is what many hedge funds do (called long/short funds). We call it constant rebalancing, where you hold some amount in a long portfolio, say, 75% and 25% in cash or in the case of shorting a put option or inverse ETF. 

Here is a simple example:

Long - $75,000

Short - $25,000

Market goes up 1%

Long - $75,750

Short - $24750

Total - $100,500

Overall, you didn’t make the 1% ($750) but still made a gain of 0.5% ($500). Now you need to rebalance back to 75/25 split. This means selling $375 in stock ($100,500x0.75=$75,375) and adding $375 to the short ($100,500X0.25=$25,125) bringing the total portfolio back to a 75/25 allocation. While this may seem a strange thing to do, you still have $100,500, you have just rearranged the allocation.  

Now the next day the market falls 0.5%. So your long portfolio goes from $75,375 to $74,998. Your short portfolio goes from $25,125 to $25,250.

The new total is $100,248. And so your portfolio to keep a 75/25% allocation would need to be $75,186 long and $25,242 short. Since your long is $74,998, you must add $188 and you do this by selling the short portfolio since it needs to be $25,062 thereby selling $180 of the short portfolio. 

After two days your portfolio is $100,248. 

The maths of the geometric return can do your head in thanks to volatility but I want to demonstrate how you can short the market and make returns when the markets becomes extremely volatile. 

I'll continue this example in future posts, so it's a work in progress.