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Why you might want to consider shorting the market

Now, I know this must be weird coming from me.

Frequent readers of this blog will have known that I am positive about the market and believe strongly in the market rising in the long run. In fact, I have written plenty of articles stating why it makes sense to keep investing in the market.

For the record, this hasn't changed.

And I'm not pessimistic about the market right now.

So what is this all about then?

Well, when I mention shorting the market, it isn't about 100% shorting the market. What I meant is that you might want to consider having part of your portfolio going against the market instead of being long in every constituent of your market.

This means that you can perhaps be 75% long, and 25% short (something along the line).

I'm sure you might be having doubts right now and be thinking why in the hell will anyone do that. Isn't this betting against yourself?

The answer is simple. Volatility.

In any portfolio, there are always systematic risks and idiosyncratic risks. Idiosyncratic risks are risks which you can minimise by diversifying your portfolio. If the constituents of your portfolios are rather uncorrelated, you could then minimise your idiosyncratic risks. However, it's hard to minimise systematic risks. Systematic risks are risks which exist to affect any stocks in the market (think COVID-19). When such black swan event hits, the whole market will be down regardless of which sector you are investing in.

Such systematic risks do sometimes bring in volatility in your portfolio (which can be easily understood via identifying the beta of your portfolio). Beta is a measure of the systematic risks in your portfolio. And the most efficient way to reduce beta is to have constituents in your portfolio that go completely against the market. This is why it might be worthwhile to have part of your portfolio shorting the market.

Let's take a look at the following portfolio choices.

Assuming your initial portfolio choice is of 50% Bitcoin and 50% SPY, below are the metrics of such a portfolio.

Such portfolio choices give you a very high gain of almost 35% (when backtested from 2014 till now)! However, it is also very volatile as the standard deviation (annualised) is 42% and the Beta is 1.29 (which means your systematic risk is 1.29 times of the general market). This is all good when the market is going up. But what if the market is going down? You will see your portfolio getting very big hits.

Now, let's say you decide to optimise this portfolio choice by minimising volatility subjecting to a 15% annual return. This is how the optimised portfolio looks like (with an inclusion of ProShares Short S&P500 being 14% of the portfolio).

Here are the metrics of the optimised portfolio.

You can see that while the CAGR for such an optimised portfolio reduces from 35% to 14%, the standard deviation (annualised) decreased significantly from 42% to 14%. Beta is now 0.77 instead of 1.29, which then represents that your portfolio has less systematic risks. Even the Sharpe Ratio increases from 0.89 to 0.93 (not shown in the screenshots above). All in all, you have a more stable portfolio albeit with a lower CAGR.

Despite this, such portfolio choices usually sit well with investors.

You might be thinking why.

This is because a low volatility portfolio can allow investors to apply leverage. It's a lot more predictable than a high beta portfolio, and leveraging could increase the returns a few times to make up for the lower value of CAGR. This is the reason why professional investors are inclined towards low volatility portfolios.

Of course, the example shown above is a simplified one. But I hope it helps to illustrate the point that it is worthwhile to consider having a small part of your portfolio shorting the market to minimise the systematic risks in your portfolio.

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