Two Heads Are Better than One: Finding Your Inner Investor
Lesson A: Understanding the Long and Short Positions
Most of us just want to get on with things in our daily lives without really having to worry about how we position ourselves with respect to fortune. Perhaps we even believe that if we do things right, fortune will reward us in some appropriate way.
Unfortunately (sorry for the pun!), when it comes to luck things tend not to work out for most of us. When things do work out for the better, we might find there was initially a bit of foreplanning and preparation involved.
I’ll come back to this. For now, a little info and a disclaimer.
This article is the first in a series dedicated to understanding investment basic strategies for The Art of the Bubble. This series is not about giving financial investment advice. I am by no means an investor. I like following the markets mostly to learn about human psychological behavior and when (if ever) moral precepts and values play a significant role. So this series is really about educating the reader on how investment psychology plays out.
In this article, we’ll explore the twin dispositions — or two heads — acting as the foundation for how investors see and relate to the world: the long position and the short position.
But first, let me just comment on a philosophical point. (I promise it will be worth your while!)
Who Needs Luck When You Can Make Your Own?
There’s a wonderfully insightful yet ambiguous quote from the ancient Greek philosopher Aristotle. He comments on the relation between what is out of human control (fortune) and what is within human control (knowledge and skill):
Techne loves tuche.
Techne is the ancient Greek word for specialized knowledge and skill. Tuche is the word for luck — both good and bad. So what does Aristotle mean when he says that the human capacity for specialized knowledge and skill loves luck?
He seems to be observing that the more one is knowledgeable and skilled in a specific domain of practical activity, the more that person will benefit when things are uncertain.
Here’s an example.
Surfing is one of the most difficult sports to do well, not just because it takes skills to balance and ride waves. What is most difficult about surfing (at least IMHO), is how to read the ocean and the way waves are breaking. This ability (or lack of it) plays a central role in how well a surfing venture goes — when and where to paddle out, when and where to catch waves, how to ride waves and when to bail.
I remember surfing Ocean Beach in Northern California for my first time when it was well overhead in height. My friend, knowing I was used to less imposing breaks, said to me after we paddled out (it took me a bit longer than my friend to make it out):
So, one rule about Ocean Beach is not to cutback on a wave unless you know you’ve got a clear path back to the line [where surfers wait for sets to roll in].
That shocked me. A cutback, where you sharply turn back towards the point where the wave is breaking, is a standard move. So why the caution?
He continued.
A lot of times cutting back will take you inside [the crash zone].
Ocean Beach is notorious for its long paddle out from shore. So riding a wave longer and cutting back puts you further inside than had you just surfed along the wave.
“Inside” is where the waves are constantly breaking. Getting caught inside can be session-ending due to the fatigue it creates — in bad situations you can drown or get slammed against underwater objects. No one wants to be caught inside on a big day.
So there it was, a little techne to help me offset any tuche. I could in some sense be the master of my own domain.
Investment is much the same in terms of being a techne. Instead of getting caught inside, investors are thinking about risk and loss. With a little techne, even a down market can be profitable. But how?
Basic to investment techne is understanding the two kinds of positions you can take with respect to investing risk. In financial matters, a “position” describes a strategy with respect to how one holds assets. Assets can include anything from stock and cryptocurrencies, to art and real estate.
What Is a Long Position?
The “first head” (or frame of mind) of investment is the long position. Think of a long position as one in which you, as an investor, believe that the asset in which you have invested has a long-term value. In other words, you believe that over time, you have good reason to think the assets value will rise in price or appreciate.
If I only would have bought Microsoft shares back in the mid to late 80s (when it increased by 100x)!
In sum, the longer you hold the asset, the more you will gain in addition to your original investment (at least before it begins to drop). Sentimentally, this type of long-term confidence is associated with being “bullish” on an investment.
So how to determine what stocks are good candidates for an increase in value?
Much of it has to do with understanding the “price to earning” (P/E) ratio of a stock. When looking at the P/E ratio of a stock, which you can find on sites like Yahoo Finance, bear in mind that most companies in the stock market have a P/E ratio of 15. So a stock much higher than 15 might indicate there is less room for growth or that it might be over-priced.
You can learn more about PE ratio and stocks for free at the The Art of the Bubble’s education series. It’s eye-opening for the newbie or even the DIYer.
What Is a Short Position?
The “second head” of investment is the short position. A “short position” is one in which you are not confident in an asset and therefore expect its price to decrease.
But a short position is more than just selling an asset due to this expectation or even staying away from it. “Shorting” an asset means
- selling an asset you own at a price higher than you expect it to be in the future,
- so you can then buy it back when it drops to a lower price.
In sum, in a short position, the investor sells the asset at a high price to “open” the short position, and buys back the asset at a lower price to “close” the position.
A more complex version of shorting an asset involves either borrowing money to buy an asset in order to open and then close a short position, or borrowing the asset in question to do the same.
Let’s look at two examples to illustrate shorting.
Example 1
- Sammy borrows $100 from his mother to buy ACME stock at $1 per share for a total of $100 shares.
- ACME drops to $0.90.
- Sammy opens his short position by selling his shares and gets $90 for his 100 shares.
- ACME continutes its decline and drops to $0.45.
- Sammy closes his position by using his $90 to buy 200 shares of ACME.
- ACME rises to $1. Sammy liquidates his ACME holding and gets $200.
- He returns $100 back to his mother while netting $100 profit.
Example 2
- Lucia borrows against her account on Coinbase to get 100 coins of $CRYPTO.
- She opens her position by selling them right away for $1000 (or $10 per coin).
- The price of $CRYPTO drops to $5.
- Lucia closes her position by using her $1000 to buy back 200 coins of $CRYPTO (doubling the initial number of coins).
- The price rises to $20 per coin.
- Lucia returns the coins she originally borrowed from Coinbase.
- With 100 coins of her own at $20, Lucia nets $2000.
Shorting may be relatively easy to grasp in theory, but in practice it’s quite speculative and risky. In the worst case scenarios, the tactic of borrowing an asset can put investors well into the red if their short play does not work out. Being “leveraged” can easily become being “over-leveraged”. And that’s when things go really poorly.
Ah, luck . . . so fickle a master to worship.
How This Can Be Applied
As I said at the outset, the content of this article and series is not to give investment advice or provide a “how-to” guide. I wrote it in mind for someone like me — that is, someone who is curious about how things work in a world vastly different from the one I tend to occupy.
A good exercise is to use what you have learned here as a lens through which you can follow market news and events. No doubt, questions will arise, which in turn will lead to more insights into the biggest and greatest forum for what is essentially legalized gambling.
This article is a part of the Crypto Industry Essentials educational program presented by The Art of the Bubble.
Though this article is credited to me, it contains some written material by Sebastian Purcell, PhD from his The Art of the Bubble education series on cryptocurrencies.
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