Hedging is for suckers, speculators, and scaredy-cats.

If you've been investing for any length of time, you've heard that refrain a time or two. The thinly veiled implication is that using options and short sales to limit downside risk is fundamentally at odds with the core principles of conservative long-term investing.

Fools, such thinking is two parts hogwash and one heaping helping of poppycock.

Your path to superior returns
In truth, the most conservative equity investor should be most interested in hedging. But don't take my word for it -- the numbers speak for themselves. According to an August 2010 Credit Suisse report, a long/short approach has produced market-trouncing returns, in both the fairly short and the relatively long term.

The table below compares the historical performance of the Dow Jones Credit Suisse Long/Short Equity Hedge Fund Index (DJCS LSEQ) versus that of the MSCI World Index.

Index Trailing 3-Year Return* Trailing 5-Year Return Trailing 10-Year Return
MSCI World Index (29.4%) 3.1% (5.1%)
DJCS LSEQ (3.9%) 31.2% 64.7%

* Returns are cumulative as of June 2010.

Furthermore, consider the following data points:

  • $100 invested in the DJCS LSEQ in 1994 grew to $465 as of June 2010, versus only $246 for a comparable investment in the MSCI World Index.
  • During the January 1994-June 2010 period, the DJCS LSEQ posted an annualized return of 9.8%, with 10% volatility. By contrast, the MSCI World Index produced annualized gains of just 5.6%, with far greater volatility (15.5%, to be exact).
  • Finally, while the recent bear market (Nov. 07-Feb. 09) rocked the MSCI World Index, quashing it by nearly 54%, the DJCS LSEQ held up relatively well, falling only 22%.

In short (no pun intended), investors have historically fared far better by incorporating into long portfolios the very short-selling strategies that are often described as highly risky and wildly volatile. How's that for irony?

But isn't the market recovering?
Sure, the prospect of adding short-selling to your investment mix can be intimidating. And the psychological hurdle rises during market upturns.

Yet while the market's been gaining and the National Bureau of Economic Research has officially closed the coffin on The Great Recession, the reality is that the economic signals are mixed. Warren Buffett, for one, isn't dancing any jigs. The unemployment rate shows little sign of easing. And at a sub-1% growth rate, real final sales reveal the U.S. recovery to be anemic.

Finally (although this hardly completes the list of gloomy tidings), a rise in August housing inventories and a flat new home sales rate prompted a tough-to-argue conclusion from Alan Abelson of Barron's: "a decent recovery without a revival in housing strikes us as a BLT on toast without bacon. It just isn't going to happen."

Which is all to say that the market may not be cheap. Yeah, it looks reasonably cheap, with the S&P500 trading at a 2010 price-to-earnings ratio of 16 and an even lower 13 times 2011 estimates. But the P/E multiple is, essentially, investor psychology in numeric form. And that means that it's nothing more predictable or rational than human sentiment.

Another bout of volatility -- whether in company earnings or economic data – would have the potential to send us back to send us back to the single-digit valuations we had in the 1930s and 1940s and, more recently, in the 1970s and 1980s.

No sirree, this is no time to shy away from hedging.

The nuts and bolts of going long while getting short
The most straightforward way to add short exposure to one's portfolio is to sell short the SPDR S&P 500 (NYSE: SPY) ETF, a market proxy. Of course, during the next downturn, certain individual stocks will fall farther and faster. And that's where it gets tricky.

Chipmaker Intel (Nasdaq: INTC) may have recently seen peak margins, possibly presaging a drop in its shares, yet its trailing P/E of 11.6 hardly looks lofty. Consumer-facing names such as Corning (NYSE: GLW) and Visa (NYSE: V) may initially look like good short candidates. Yet the former's shares could be buoyed by growing industry adoption of its Gorilla Glass product, and the latter has the structural growth of debit cards at its back.

Likewise, economically sensitive commodity companies such as Freeport-McMoran Copper & Gold (NYSE: FCX) and BHP Billiton (NYSE: BHP) were a short-seller's dream in late 2008, but even if commodity demand is set to wane, the possibility of another round of quantitative easing (and possibly ensuing dollar weakness) could keep these stocks jumping.

Personally, I'm toying with the idea of shorting salesforce.com (NYSE: CRM), a name that trades at a 70 forward P/E versus expected long-term earnings growth of only 28%. Still, my colleague Tim Beyers argues that such a move could be misguided.

Fret not
As with long investments, the most profitable short positions are usually those that the market initially fails to recognize. Identifying accounting irregularities through cash-flow-versus-earnings discrepancies and problems with accounts receivable or days sales outstanding are excellent ways to identify such prospects.

At the end of the day, though, the key to surviving a market juggernaut is to have at least some kind of hedge. That could be the low-cost, high-risk, high-return bear put spread, the plain-vanilla tactic described above, or any of a number of contrarian-based positions.

Now, for those who are intrigued by the prospect of outperforming the market through a long/short portfolio but reluctant to make those dicey short decisions on their own, the Motley Fool will soon launch Motley Fool Alpha, a real-money portfolio consisting of our actual capital. You'll have the opportunity to replicate our portfolio, trade for trade, in your own account. If you would like to learn more as soon as details are available, click here.

Fool contributor Mike Pienciak is short SPY common shares but holds no financial interest in any other company mentioned in this article. Intel is a Motley Fool Inside Value selection. Salesforce.com is a Motley Fool Rule Breakers pick. The Fool owns shares of Intel. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool is long (and unhedged) its disclosure policy.