Fooling Some of the People All of the Time, A Long Short Story

It would be foolish to assume that our counterparty is uninformed or unsophisticated. In most circumstances, today’s seller has followed the situation longer and more closely than we have, has previously been a buyer, and has now changed his mind to become a seller. Even worse, the counterparty could be a company insider or an informed industry player working at a key supplier, customer or competitor. Some investors believe they have an advantage trafficking in stocks that have minimal Wall Street analyst coverage. We believe it doesn't matter if a stock is “underfollowed” because the person we are buying from probably has followed the stock and we need to have a better grasp on the situation than he does. Given who that may be, our burden is high.

If we are uncomfortable with the risk in a position, we simply reduce or eliminate it. By having a portfolio of worthwhile longs and worthwhile shorts, we achieve a partial market hedge without having to spend capital on negative-expected-return propositions.

...we avoid “evolving hypotheses.” If our investment rationale proves false, we exit the position rather than create a new justification to hold. We exit when our analysis is wrong or we just can ’ t stand the pain, rather than when the market simply disagrees longer than we had imagined.

As Joel Greenblatt pointed out in You Can Be a Stock Market Genius Even If You’re Not Too Smart: Uncover the Secret Hiding Places of Stock Market Profits, holding eight stocks eliminates 81 percent of the risk in owning just one stock, and holding thirty two stocks eliminates 96 percent of the risk. Greenblatt concludes, “After purchasing six or eight stocks in different industries, the benefit of adding even more stocks to your portfolio in an effort to decrease risk is small. ”