Here is Part 2 of portfolio management highlights extracted from an interview with Stanley Druckenmmiller in Jack D. Schwager’s book The New Market Wizards. Be sure to check out the juicy bits from Part 1. Druckenmiller is a legendary investor, and protégé of George Soros, who compounded capital ~30% annualized since 1986 before announcing in 2010 that his Duquesne fund would return all outside investor capital, and morph into a family office.
Portfolio Management
“I’ve learned many things from him [George Soros], but perhaps the most significant is that it’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.”
This is the very essence of portfolio management. We all have endless opinions on ideas, inflation, direction of markets, etc. But it's what we do with these opinions - the conversion into P&L and trackrecord - that ultimately determines our success or failure as investors.
In this industry, sometimes people become obsessed with "being right" or "proven right" - which is likely a natural behavioral tendency. But I agree with Druckenmiller, it doesn't matter if you're right or wrong. When utilized skillfully, portfolio management has the ability to amplify correctness and mute errors.
When To Buy, When To Sell, Sizing
“Soros has taught me that when you have tremendous conviction on a trade, you have to go for the jugular. It takes courage to be a pig. It takes courage to ride a profit with huge leverage. As far as Soros is concerned, when you’re right on something, you can’t own enough.”
Making Mistakes, When To Sell
“Soros is also the best loss taker I’ve ever seen. He doesn’t care whether he wins or loses on a trade. If a trade doesn’t work, he’s confident enough about his ability to win on other trades that he can easily walk away from the position. There are a lot of shoes on the shelf; wear only the ones that fit. If you’re extremely confident, taking a loss doesn’t bother you.”
Closing out a losing position takes a lot of courage. It is usually a task that is easier said than done because it goes against our natural psychological tendency to avoid confronting or admitting our mistakes. The act of selling a losing position echoes of finality – no hope for a brighter outcome just around the corner, no possibility of savaging the situation.
However, there are also benefits. As Druckenmiller points out, it lets you walk away to fight another day – perhaps at an easier battle. Also, it frees up mental and time capacity in not having to babysit that losing position.
Ask yourself honestly: how much time did you spend in the chaotic era of 2008-2009 babysitting losers vs. concentrating on finding new opportunities?
Cash
“By mid-1981, stocks were up to the top of their valuation range, while at the same time, interest rates had soared to 19 percent. It was one of the more obvious sell situations in the history of the market. We went into a 50% percent cash position, which, at the time, I thought represented a really dramatic step. Then we got obliterated in the third quarter of 1981…Well, we got obliterated on the 50 percent position we still held.”
“You have to understand that I was unbelievably bearish in June 1981. I was absolutely right in that opinion, but we still ended up losing 12 percent during the third quarter. I said to my partner, ‘This is criminal. We have never felt more strongly about anything than the bear side of this market and yet we ended up down for the quarter.’ Right then and there, we changed our investment philosophy so that if we ever felt that bearish about the market again we would go to a 100 percent cash position.”
Below, I highlight two sides to this perennial cash debate:
(Some) Fund Managers say: My goal is to compound capital (and to build an awesome trackrecord). Holding a cash balance makes sense at certain times of the cycle, such as when I don’t see any worthwhile opportunities (2005-2007), and this will prevent (temporary) impairments of capital. However, I will stay vigilant with both eyes open, and redeploy the moment opportunities reemerge. If you leave the cash with me, I won’t have to spend time raising capital at exactly the moment when I should be spending all of my time focused on investing (2008-2009).
(Some) Clients say: I am fully aware of market cycles and the merits of holding cash while waiting for better bargains. However, when I gave your fund capital to invest, I have already allotted for a cash balance elsewhere in my overall portfolio. If you move toward cash, it skews my actual cash exposure to higher than anticipated within my asset allocation. Therefore, I want you to be fully invested at all times.
There is no right or wrong answer here – both sides have valid points. At its core, this debate originates from a mandate communication issue. Before taking on a client, make sure he/she understands your views on cash balance. Before allocating capital to a fund, make sure the “cash mandate” complements your asset allocation strategy.