George Soros. Carl Icahn. Dan Loeb. Steve Cohen. Stan Druckenmiller.
Titans of the hedge fund investment world.
Soros brought down the Bank of England. Icahn won big on Herbalife. Dan Loeb forced change at Yahoo.
The secret to their success?
Here are five investment lessons from these legendary hedge fund investors that you can apply to your investment portfolio today:
1. Develop an investment thesis
An investment thesis is the underlying reason why you are investing in a stock. With the exception of momentum traders and quants, most hedge fund investors develop an investment thesis before they deploy capital. For example, the investment thesis can mean the stock is undervalued and underappreciated by investors or there may be a catalyst such as a potential take-out acquisition on the horizon.
Hedge fund investors conduct rigorous fundamental research, build financial models and identify catalysts that will propel the current share price toward their target share price. They don’t invest blindly based on stock tips from a broker or a news article. Rather, they invest in sectors and companies they understand and where they have done their homework.
Warren Buffett, although not a hedge fund investor, only invests in companies he understands. If he can’t understand the business model, he passes on the investment opportunity.
Key Takeaway: Only invest in companies you understand. Develop a thesis of why you are investing. Do your homework and understand the numbers behind the company’s products and services.
In a bull market, it’s easy to expect that a company’s share price will rise 10%. However, hedge fund investors don’t think of investments as a unidirectional bet. Rather, each investment has a risk-reward ratio. If an investor is long a stock, the reward is the probability that the share price will rise, and the risk is the probability that the share price will fall. Share prices rise and fall for several reasons, including financial performance, company or industry news, competitor dynamics, analyst ratings and other factors.
Before you invest, assess the probability of the risk-reward of each investment. You can develop the reward-risk ratio by reading analyst research, reviewing the company’s public filings and management presentations, or developing your own financial projections.
For example, if you think that there is a 50% probability that a share price could rise or fall, that’s probably a poor investment choice. Since the reward-risk ratio is 1:1, it’s no different than flipping a coin.
Key Takeaway: Look for investment opportunities where the reward-risk ratio is at least 3:1, meaning the upside potential is three times greater than the downside potential of the company’s share price.
3. Concentrated Bets
You’ve probably been advised repeatedly that you should maintain a diversified portfolio to protect against one company adversely impacting the rest of your investments. For many investors, particularly those who are risk adverse, investment diversification is their best bet. An index fund or ETF that invests in the broader stock market, such as the S&P 500, can provide ample diversification.
While it depends on the hedge fund, some hedge fund investors maintain a concentrated portfolio of 10-15 stocks. Why? These investors have strong conviction in their investments, supported by financial analysis and independent research.
Key Takeaway: Understand and assess your risk tolerance. Concentrated bets have the potential for outsized investment returns – up or down.
4. Hedge your bets
Like its name suggests, hedge funds typically are not 100% long the stock market. Rather, they employ some form of financial protection to guard against share price declines due to market or company-specific events. Depending on market factors, some hedge funds are 80% long (and 20% short) while other hedge funds are market neutral (meaning they are neither market long or market short).
Hedge funds use all types of hedging strategies. Some include:
- Buying a put option to protect against a long position
- Shorting a competitor of the stock they are long
- Longing an industry leader and shorting an industry laggard
- Longing an undervalued stock and shorting an overvalued stock
Key Takeaway: Protect your investments with some form of a hedge. Before shorting a stock or using options, however, check with your investment advisor and be sure you understand all the inherent risks associated with these strategies.
5. Cut Investment Losses
No investor is perfect. The best investors are often wrong, despite all the research and financial analysis. However, when they are wrong, they know when to cut their losses. Yes, you may sell the stock and the share price could then rebound. But instituting discipline in your investment process will save you money in the long-run.
Key Takeaway: Develop your own threshold to sell a stock when its share price falls. One rule of thumb is a 10%-15% decline below your purchase price. You may have a threshold that is higher or lower, but choose a loss rate that works best for your investment needs and stick with it.
Zack Friedman is a former hedge fund investor and the founder of Make Lemonade, a personal finance platform which also offers free and unbiased advice to over 40 million borrowers to manage, repay and save money on their student loans. Follow Zack on Twitter and read his columns in Forbes.