In one of the first posts I have done on this blog, I have described my investment framework. (https://exploitingmistermarket.com/2019/08/06/my-investment-framework/) I think it is critical to have a well grounded framework that starts from first principles and that matches a person’s analytical and behavioral traits and keeps them in check. Generally speaking, investors are much more concerned about security selection than about how to build their portfolio. This is a mistake, I think both are crucial. Warren Buffett would agree. He said the following: “Success in investing doesn’t correlate with IQ once you’re above the level of 125. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.” When I look back at my own investing/trading history, while I have made plenty of analytical mistakes, it was poor portfolio management that has cost me the most. That’s why in this blog post, I will take a look at my own portfolio management framework.
So, what is a good framework? There are a lot of different ideas out there. One which has gained a lot of followers lately is passive investing. It basically dollar averages into a broad market index. This is a very sensible approach for a lot of people. I do think however that much of the success of passive investing has to do with this 10 year old bull market. I am afraid that these people will panic during a downturn and abandon their approach. I believe I have value to add by selecting the right securities and constructing my own portfolio so this is not a sensible approach for me. Another approach is the one Warren Buffet preaches, the punch card approach. You only need a few very well-researched ideas which you let compound for eternity. I think this reasoning is flawed and I’ll describe why during the discussion of my own framework.
Think of the potential downside first. Above all, do no harm.
This is the low-hanging fruit in my case. I need to protect myself against my worst behavioral biases which cause me to be way too optimistic on position sizing and time frame. A lot of mistakes I have made in the past were based on the following recipe: a sound analysis, leading to taking a way-too-big position that had to play out in a way too short time frame to make it work. There are a number of ways to counter this behavior:
Trade in and out slowly. In the past, I would come across a name which looks interesting and even before I would have done the minimal amount of research I would already have bought into a big position. And while I do believe it is ok to take a small position on a limited amount of research, I think it is good to go slow. What are the odds you will be buying the bottom of the market anyway?
Diversify the portfolio. This idea is probably more controversial. A lot of value investors are concentrating heavily into a few names. After all, why put money in your fifteenth best idea while you could also put money in your very best idea. I find this a dangerous way of thinking. Granted, they will also tell you that you need to know the company inside out. But I don’t feel quite as confident that I can ever know a company that well, or project its return on investment that accurately. Focusing on one company very deeply does not necessarily make your analysis much better, it will make your confidence in your analysis of the company higher though. Something I want to avoid. All in all, I would rather have 10 positions yielding 20% than 1 yielding 22%. First of all, it is less error prone and secondly I can profit from the rebalancing premium. More about this in the next part.
Size positions in the portfolio based on edge and probability.
Whereas the first part of the framework was to avoid errors, this part will focus more on the upside. Another common investment wisdom I want to refute is the buy and hold approach. This ties in with the “the market is your servant, not your master” tenet of value investing. A lot of value investors interpret this tenet as not being affected or forced out of their investment if the quoted price goes down. I think this is good advice but I do not only want to be unfazed by Mr. Market, I want to exploit his behavior. I want to take advantage of the discrepancy between the quoted price and what I deem to be the company’s intrinsic value. Let’s give a concrete example. Imagine a stock that is projected to earn 20% annualized and has a weighting of 5% in the portfolio. If that stock moves up by 50% the next day and the other stocks have not moved, the new portfolio weighting of that stock is now 7.5% and the projected yield is now around 13%. Buy and hold would prescribe to do nothing, basically allocating a higher percentage of the portfolio to a less interesting stock. The stock, because of the lower projected yield, deserves a lower than 5% weighting in the portfolio now. This way of constructing a portfolio will not be able to hold great companies when they become overpriced but will position the portfolio for the highest expected value and will take advantage of the volatility in the market by rebalancing.
It generally pays off to learn from the way people do things in other disciplines. In investing there is a lot to be learned from the way professional gamblers think about optimal sizing. More specifically, how to grow wealth in the most optimal way if you know the probabilities and the edge of the bet. In investing it is very hard to quantify these parameters but I think the concepts carry over quite well. Everyone knows that you ought to take bets with a positive expected value but the more difficult question is how much of your wealth to bet in a repeated game. Gamblers have solved this problem a long time ago. (Kelly Criterion) A small thought experiment can show how it works. Imagine the following two bets with the following probabilities and payouts:
- Win $10 10% of the time, lose $1 90% of the time. Expected value is $0.1
- Win $0.222 90% of the time, lose $1 10% of the time. Expected value is $0.1
Both bets should be accepted but one can intuitively see that if you could take this bet multiple times, the second bet, while having the same expected value, should be done in bigger size and will compound a lot better. The optimal proportion in the first case is 1% of the bankroll, in the second one 45%. Without going further into specifics of how to calculate this, it is clear that when the dispersion of potential returns is lower, you should invest a higher proportion. That’s why I will define my portfolio management parameters based on expected edge and dispersion of potential outcomes. This way of diversifying and sizing positions opens up a huge universe of stocks which are ignored by value investors, stocks that are potentially a “zero”. When you run a concentrated portfolio these companies are uninvestable. However when the potential upside is high enough, adding very small stakes of these stocks, might dramatically improve the expected return of the portfolio.
With this framework in mind, I will define a very clear and systematic way of building my portfolio in a future blog post. I want it to be systematic because this part of the investing process is the most prone to behavioral biases.
