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.

Margin Accounts

For the average person, the purchase of a home or automobile is usually made using a small amount of personal funds and a much larger percentage of money that's borrowed from another source. Most investment securities can be bought in exactly the same manner. When an investor decides to buy securities on margin a special account, known as a margin account, must be opened with a stock brokerage firm. The investor supplies a down payment and the firm lends the remaining balance for the transaction and actually purchases the securities for the investor. Up to 50% of the purchase price of securities bought in this manner can be borrowed funds. The investor can therefore buy up to twice as much market value of stock on margin as is possible using his or her own cash (for those securities which can be bought on margin; not all can). This use of borrowed funds to increase the percentage of profit is known as leverage. This leveraged position creates for the investor an opportunity to make more money for a given sum of investment dollars. At the same time, however, it creates the opportunity for losses which are not limited to the initial investment. These losses can occur very quickly and be quite extreme. Another consideration in margin trading is that interest is charged by the broker on the borrowed funds (known as the debit balance), which can be substantially more than the dividends and interest being earned by the purchased securities. Margin trading is a relatively sophisticated market technique and must be approached with great care. Due to the leveraged position, although greater gains can be achieved than will full cash transactions, the investor is exposed to the risk of deep losses. If the market value of the margined securities drops significantly, the brokerage firm will issue a maintenance- or margin call, which is a demand that the investor deposit more collateral money into the margin account. If the investor cannot or chooses not to deposit more funds, the broker will sell some or all of the securities to bring the account back to a properly margined condition. Normally these forced sales are executed in rapidly falling markets, which actually serves to "lock in" the investor's losses. Securities purchased on margin are not forwarded to the investor. They remain with the brokerage firm as collateral for the debit balance. Such securities are said to be in street name; they're held by the broker in the broker's name (the registered owner), but the investor is the true or beneficial owner. The brokerage firm sends the investor a monthly statement of the account showing the securities and cash that are being held for the investor (this is done for cash accounts, as well). The account will refer to the investor's position as "long" or "short": "long is a positive position in which the investor owns a particular stock; "short" refers to the position of owing stock which was borrowed to complete a sale. Trades are posted to the account on the settlement date (the date that the purchased securities must be paid for), which is generally three business days after the actual trade date. For options and government securities, the settlement date is normally the next business day.