No market risk

Systemic risk, or market risk, is the portion of risk that cannot be eliminated by means of diversification. Even if you were to hold one share of each of the 6,000 different listed stocks, when the market crashes, your portfolio will go down in value, although you are broadly diversified.

Studies based on the correlation of the hundred largest stocks in the S&P 500 index have shown that market risk today is larger than specific risk; in other words, if you invest in the stock markets, systemic risk is your worst enemy. One proof of this is the negative returns of otherwise smart stock pickers in bear markets.

So what can we do? The modern portfolio theory teaches us that the most efficient portfolios combine assets which have a perfect negative correlation.

Consider the following situation: every even month, stock A goes up 2% and every odd month, it goes down 1%. On the contrary, stock B goes up 2% every odd month, and it goes down 1% every even month. While both exhibit volatility, a portfolio composed of 50% of A and 50% of B would be a winner every month.

Which two asset classes have a correlation of -1? Betting on stocks to go up (also called "long only") and betting on stocks to go down ("short selling"), for example. Of course, betting $100 that IBM stock price will rise, while simultaneously betting $100 that IBM share price will go down will produce a performance of zero, minus transaction costs.

So we will need to generate some robust alpha. Another nice thing about being market neutral is that you can use any alpha to generate performance.