LEVEL: BEGINNER
The plainest and simplest active investment strategy is “long only”, in which the investor only buys shares in companies that he or she expects will rise in value. The goal of the long only investor is to buy low and sell high, and long-only investors will typically define a specific profit level that becomes their goal. They may achieve this through dividends, capital appreciation (the rising value of the stock), or in the exercise of call options that allow them to effectively buy stocks at a huge discount to their real market value.
Long only investors differ from buy and hold investors in that they do not hold forever, and can often have a short-term time horizon for their portfolios and investments. Of course, an investor can overlap between the two, and it’s common for a buy-and-hold investor to be long only.
Several hedge funds are long only for two reasons. The first is risk management; the risks in shorting are extreme and require a level of due diligence that some investors find yield far too small a return to be worthwhile. If they spend that time and energy in long only bets, they find better returns on their investments. Likewise, investors might develop a particular proprietary model they use to assess the growth of a company, which will only work for long only investing.
Long-only investors will not always analyze stocks in the same way, and will typically utilize different methods of assessing equities before buying and selling. Short-term trades can be purely “momentum plays” meaning that a stock is rising in value quickly and the investor wants to participate for the short-term gains. They may actually dislike the fundamental prospects for the stock in the long term, but they hope to find an entry and exit point that will yield a strong return in the short term. Similar to buy-and-hold investors, the long-only investor may rigorously analyze the fundamentals of companies for midterm and longer term investments.
The most difference between long-only investing and other basic investment strategies is the active management style. Long-only investors actively look for new stocks to add to the portfolio and constantly review stocks currently held to see which can and should be sold. Trading may not occur daily and this should not be confused with day trading. Many long-only investors will keep a position for months or even years.
Secondly, in comparison to other complex strategies, long only investors generally do not hedge their positions with the use of short sales or derivatives contracts. This fundamental fact gives them 100% full directional exposure to the market. Although this makes the portfolio strategy easier to understand, it may not perform the best in various points of a market cycle. Most mutual fund portfolio managers are long only and they typically have an investment horizon of at least 2-3 years.
Downsides
Similar to the buy and hold strategy, long-only investors face the risk of poor investment selection. It cannot be overemphasized how crucial the ability to select winning stocks in any time frame is to this strategy. In order for this strategy to be successful, the investor has to consistently choose more winners than losers, no matter where the market is in a general market cycle.
The second major downside is the exposure to market timing risk, which is the specific entry and exit point of an investment. Despite technical charts and other fancy indicators, it is very difficult to accurately predict the high and low of an investment, so a long only investor may find that they jump into a market just at its height for a certain period. They can mitigate this risk by employing stop and limit orders to enter and exit trades. This also helps to remove emotion from investing which is generally why many investment strategies fail.
The third major downside is the potential to create a concentrated portfolio that increases your overall risk exposure. It is very difficult for an investor to accurately monitor several stocks without the assistance of a full research team, like many professionals money managers are able to do. Thus with this limitation it is possible to build a portfolio highly concentrated in a few stocks, which ultimately drives the performance of the entire portfolio. As stated earlier, if one’s ability to select winning stocks is less-than-stellar, the risk of portfolio concentration increases substantially.
The last major downside is directional bias. Long-only investors are heavily weighted to perform best when the markets are rising due to their lack of hedging. The lack of hedging through the use of short sales and other derivative instruments can make this strategy very risky in bear markets. However, investors are able to avoid other risks that are associated with margin accounts, short sales, and derivatives trading.