Being an investor for the past 6-8 months, after looking at the short bull and bear runs, I have come to a conclusion that there is no way to predict certain events in the markets that prove to be very crucial. In hindsight, everyone has reasons for the abnormal surges and falls in the equity market, but I don’t think anyone can predict events like the Egyptian crisis, issues with Libya, or other black swan events.
So how can one eliminate the risk involved in investing in an unpredictable market? One of the ways to do it is by using a Market Neutral Strategy. If I am bullish on one stock and was to take a long position on it, I need to take a short position on another stock which I am bearish on. In this way, I hedge my profit and losses if the market goes haywire. In this situation, a good fundamental stock would not go down as much as a not so good fundamental stock in a bear run and vice versa. In this way, I am only investing in the quality of the company.
To quote an example from my experience, I used to follow the automobile sector very closely. According to me, Tata Motors was a very good buy but I wasn’t as bullish about Ashok Leyland. So I went long on Tata Motor and short on Ashok Leyland. In December, Tata Motors was trading at around INR 1200.0-1250.0 and Ashok Leyland was trading around INR 70.0-75.0. I did not end up making a lot of money back then because I got out of it quickly, but if I had held on to it, I would have made good money on it (although the market is down from 6000 levels to 5500 now). Tata Motor is now trading at INR 1150.0, whereas Ashok Leyland is trading at INR 50.0.
I also used to follow Bharti Airtel and Idea. According to me, although I did not like the telecom sector too much, Airtel was a better telecom company as compared to Idea, due to its aggressive growth strategies. In December, Airtel was trading at around INR 330.0 and Idea was trading around INR 70.0. If I had actually went ahead with my market neutral strategy, I still would have ended up making money as Airtel is still trading at around INR 330.0, whereas Idea is trading at around INR 60.0 (all this when the Nifty went down ~10.0%).
If you’ve noticed, I have used the market neutral strategy on stocks in the same sector. It helped me eliminate sector-specific risk, though the strategy is not limited to stocks in the same sector. One can use this strategy across different sectors, one stock against the index, one index against another index, etc.
(Investments are subject to market risk)