Cross-Pollination: Volatility & Options

In our continual search for differentiation in this fiercely competitive investment biosphere, we remain intrigued by the idea of cross-pollination between investment strategies. After all, regardless of strategy, all investors share a common goal: capital compounding through the creation of return asymmetry over time. Fundamental investors often shy away from options and volatility, labeling them as too complicated and esoteric. Are they truly that complicated, or merely made to seem so by industry participants enamored with jargon and befuddlement?

In this brief video (8:30-8:35am time slot), Richard “Jerry” Haworth of 36South shares a few thoughts & observations on options and volatility that all investors can incorporate into their portfolios.

Summary Highlights:

Options (a type of “volatility assets”) are a potentially rich source of alpha since pricing in options market are mainly based on models, not fundamental analysis. Occasionally massive mispricings occur, especially in long-dated options.

Most wealth is generated by luck or asymmetry of risk & return. Most options have asymmetry. Long options positions (especially long-dated) behave like “perfect traders” – they always obey stop loss (downside is limited by premium outlay) and positions are allowed to run when working in your favor (especially as delta improves for out-of-the-money options).

Options also have natural embedded leverage (especially out-of-the-money), providing cheap convexity. Better than debt, because it’s non-recourse – max loss is limited to premium outlay.

Volatility (a $65 trillion notional market) is counter intuitive – people tend to sell vol when low, and buy when high – great for contraians who like to buy low and sell high. Natural human behavioral bias makes it so this phenomenon will never go away.

Portfolio managers are in the “business of future-proofing people’s portfolios” – seeking to maximize return while minimizing risk and correlation. The “further you get away from $0 the more you are future-proofing a portfolio…” But this is extremely difficult to implement well, especially in low interest rate environment where future expected returns are difficult to find.

Short-term downside volatility is noise. But long-term volatility on the downside is permanent loss of capital – counter to goal of “future-proofing” portfolios. When people think about risk, they tend to use volatility as proxy for risk, but this is a very limiting definition. Volatility has been minimized by low rates, which has lead people to mistakenly think that we’ve minimized risk since we’ve minimized volatility. Classic mistake: people are now taking on “risk and correlation that they don’t see…for returns that they do see.”

Correlation – only important in crisis, no one cares about correlation when asset prices going up. Perceived vs. Actual Correlation: dangerous when you think you have a “diversified” portfolio (with low correlation between assets) when in reality correlation of assets in portfolio actually very high. People focus on minimizing correlation, but often fail when truly need minimized correlation (example: during a systemic crisis).

Writing / shorting volatility (such as selling options) in a portfolio increases yield & adds to expected return, but makes correlation and risk more concave, with a tendency to snowballs to downside. Whereas long volatility assets are convex, it takes slightly from return (cuz premium outlay) but offers uncapped expected return on the upside.

A Chapter from Swensen's Book

Given his reputation and the title of the book, we would be remiss not to feature excerpts from David Swensen’s Pioneering Portfolio Management. Below are portfolio construction & management highlights from Chapter 6: Portfolio Management. The manager anecdotes in this chapter are fairly interesting too, providing readers a window into how an institution (Yale/Swensen) evaluates its external managers. Portfolio Management, Risk, Expected Return

“In a world where risk correlates with return, investors hold risky assets in pursuit of returns exceeding the risk-free rate. By determining which risky assets are held and in what proportions, the asset allocation decision resides at the center of portfolio management discussions.”

“…the complexities of real-world investing drives a wedge between the easily articulated ideal and the messy reality of implementing an investment program.”

Putting aside whether you agree that risk is correlated with return, it is safe to postulate that markets are (usually) efficient enough to require investors bear some degree of risk, in the pursuit of any rate of return above the risk-free-rate. The portfolio management process involves determining which returns are worthwhile pursuing given the associated risks, and relative to the risk-free rate. However, sh*t happens (“a wedge between the easily articulated ideal and the messy reality”). So how does one navigate through the “complexities” and “messy reality” of implementation? Read on…

“Some investors pursue active management programs by cobbling together a variety of specialist managers, without understanding the sector, size, or style bets created by the more or less random portfolio construction process…Recognizing biases created in the portfolio management process allows managers to accept only those risks with expected rewards.”

“Disciplined implementation of asset allocation policies avoids altering the risk and return profile of an investment portfolio, allowing investors to accept only those active management risks expected to add value.”

“Concern about risk represents an integral part of the portfolio management process, requiring careful monitoring at the overall portfolio, asset class, and manager levels. Understanding investment and implementation risks increases the chances that an investment program will achieve its goals.”

“Unintended portfolio bets often come to light only after being directly implicated as a cause for substandard asset class performance.”

Awareness of what you own (the risks, expected return, how the holdings interact with one another, etc.) is an absolutely necessity. This concept has surfaced many times before on PM Jar, likely indicating that it is an important commonality across different investment styles and strategies.

Leverage, Expected Return, Risk, Volatility

“By magnifying investment outcomes, both good and bad, leverage fundamentally alters the risk and return characteristics of investment portfolios…leverage may expose funds to unanticipated outcomes. Inherent in certain derivatives positions, leverage lurks hidden in many portfolio, coming to the light only when investment disaster strikes.”

“Leverage appears in portfolios explicitly and implicitly. Explicit leverage involves use of borrowed funds for pursuit of investment opportunities, magnifying portfolio results, good and bad. When investment returns exceed borrowing costs, portfolios benefit from leverage. If investment returns match borrowing costs, no impact results. In cases where investment returns fail to meet borrowing costs, portfolios suffer.”

“…portfolio returns should exceed leverage costs represented by cash, the lowest expected return asset class.”

“Sensible investors employ leverage with great care, guarding against introducing materials excess risk into portfolio characteristics.”

Traditional academic leverage discussions focuses on the theoretical spread between cost of borrowed capital and what is earned through reinvestment of borrowed capital. While this spread is important to keep in mind, the actual utilization and implementation of leverage in a portfolio context is far messier that this elegant algebraic formula. There are many other articles on PM Jar discussing leverage in a portfolio context.

Leverage, Risk, Volatility, Derivatives

“Simply holding riskier-than-market equity securities leverages the portfolio…the portfolio either becomes leveraged from holding riskier assets or deleveraged from holding less risky assets. For example, the common practice of holding cash in portfolios of common stocks causes the domestic equity portfolio to be less risky than the market, effectively deleveraging returns.”

“Derivatives provide a common source of implicit leverage. Suppose an S&P 500 futures contract requires a margin deposit of 10 percent of the value of the position. If an investor holds a futures position in the domestic equity portfolio, complementing every one dollar of futures with nine dollars of cash creates a position equivalent to holding the underlying equities securities directly. If, however, the investor holds five dollars of futures and five dollars of cash, leverage causes the position to be five times as sensitive to market fluctuations.

Derivatives do not create risk per se, as they can be used to reduce risk, replicate positions, or increase risk. To continue with the S&P 500 futures example, selling futures against a portfolio of equity securities reduces risks associated with equity market exposure. Alternatively, using appropriate combinations of cash and futures creates a risk-neutral replication of the underlying securities. Finally, holding futures without adequate balancing cash positions increases market exposure and risk.”

One must tread carefully when utilizing derivatives not because they are derivatives, but because of the implicit leverage that comes with derivatives.

Liquidity

“Less liquid asset types introduce the likelihood that inability to vary exposure causes actual allocations to deviate from target levels…Since by their very nature private holdings take substantial amounts of time to buy or sell efficiently, actual portfolios usually exhibit some functional misallocation. Dealing with the over- or under-allocation resulting from illiquid positions creates a tough challenge for the thoughtful investor.”

“…rebalancing requires sale of assets experiencing relative price strength and purchase of assets experiencing relative price weakness, the immediacy of continuous rebalancing causes managers to provide liquidity to the market.”

Expected Return, Risk

“Returns from security lending activity exhibit patterns characteristic of negatively skewed distributions, along with their undesirable investment attributes. Like other types of lending activity, upside represents a fixed rate of return and repayment of principal, while downside represents a substantial or total loss. Unless offset by handsome expected rates of return, sensible investors avoid return distributions with a negative skew…negatively skewed return pattern exhibits limited upside (make a little) with substantial downside (lose a lot), representing an unattractive distribution of outcomes for investors.”

Klarman’s Margin of Safety: Ch.13 – Part 3

This is a continuation in our series of portfolio construction & management highlights extracted from Seth Klarman’s Margin of Safety. In Chapter 13 (Portfolio Management and Trading) - Part 3 below, Klarman shares his thoughts on a number of portfolio construction and management topics such as risk management, hedging, and correlation.

Portfolio Management, Risk

“The challenge of successfully managing an investment portfolio goes beyond making a series of good individual investment decisions. Portfolio management requires paying attention to the portfolio as a whole, taking into account diversification, possible hedging strategies, and the management of portfolio cash flow. In effect, while individual investment decisions should take risk into account, portfolio management is a further means of risk reduction for investors.”

“….good portfolio management and trading are of no use when pursuing an inappropriate investment philosophy; they are of maximum value when employed in conjunction with a value-investment approach.”

Portfolio management is a “further means” of risk management.

Cash, Liquidity, Risk, Expected Return, Opportunity Cost

“When your portfolio is completely in cash, there is no risk of loss. There is also, however, no possibility of earning a high return. The tension between earning a high return, on the one hand, and avoiding risk, on the other, can run high. The appropriate balance between illiquidity and liquidity, between seeking return and limiting risk, is never easy to determine.”

Everything in investing is a double-edged sword. See Howard Marks’ words on this same topic. 

Risk, Diversification

“Even relatively safe investments entail some probability, however small, of downside risk. The deleterious effects of such improbably events can best be mitigated through prudent diversification. The number of securities that should be owned to reduce portfolio risk to an acceptable lever is not great; as few as ten to fifteen different holdings usually suffice.”

“Diversification is potentially a Trojan horse. Junk-bond-market experts have argued vociferously that a diversified portfolio of junk bonds carries little risk. Investors who believed them substituted diversity for analysis and, what’s worse, for judgment…Diversification, after all, is not how many different things you own, but how different the things you do own are in the risks they entail.”

Awhile back, we posed an interesting question to our Readers, would you ever have a 100% NAV position (assuming you cannot lever to buy/sell anything else)? And if not, what is the cutoff amount for “excessive” concentration? 

Risk, Hedging, Expected Return

“An investor’s choice among many possible hedging strategies depends on the nature of his or her underlying holdings.”

“It is not always smart to hedge. When the available return is sufficient, for example, investors should be willing to incur risk and remain unhedged. Hedges can be expensive to buy and time-consuming to maintain, and overpaying for a hedge is as poor an idea as overpaying for an investment. When the cost is reasonable, however, a hedging strategy may allow investors to take advantage of an opportunity that otherwise would be excessively risky. In the best of all worlds, an investment that has valuable hedging properties may also be an attractive investment on its own merits.”

Correlation, Volatility

“Investors in marketable securities will not have predictable annual results, however, even if they possess shares representing fractional ownership of the same company. Moreover, attractive returns earned by Heinz may not correlate with the returns achieved by investors in Heinz; the price paid for the stock, and not just business results, determines their return.”

Different types of correlation:

• portfolio returns to indices/benchmarks
• portfolio assets/securities with each other
• price performance of assets/securities with the actual underlying operating performance

Klarman's Margin of Safety: Ch.13 - Part 1

Many years ago, Seth Klarman wrote a book titled “Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor.” It is now out of print, and copies sell for thousands on eBay, etc. This marks our first installment of portfolio construction & management highlights extracted from this book. We begin this series not with Chapter 1, but more appropriately with Chapter 13 which discusses “Portfolio Management and Trading.” In Part 1 below, Klarman offers some differentiated insights on portfolio liquidity and cash flow.

Portfolio Management, Liquidity, Cash, Catalyst, Duration, Mistakes, Expected Return, Opportunity Cost

“All investors must come to terms with the relentless continuity of the investment process. Although specific investments have a beginning and an end, portfolio management goes on forever.”

“Portfolio management encompasses trading activity as well as the regular review of one’s holdings. In addition, an investor’s portfolio management responsibilities include maintaining appropriate diversification, making hedging decisions, and managing portfolio cash flow and liquidity.”

“Investing is in some ways an endless process of managing liquidity. Typically an investor begins with liquidity, that is, with cash that he or she is looking to put to work. This initial liquidity is converted into less liquid investments in order to earn an incremental return. As investments come to fruition, liquidity is restored. Then the process begins anew.

This portfolio liquidity cycle serves two important purposes. First…portfolio cash flow – the cash flowing into a portfolio – can reduce an investor’s opportunity cost. Second, the periodic liquidation of parts of a portfolio has a cathartic effect. For many investors who prefer to remain fully invested at all times, it is easy to become complacent, sinking or swimming with current holdings. ‘Dead wood’ can accumulate and be neglected while losses build. By contrast, when the securities in a portfolio frequently turn into cash, the investor is constantly challenged to put that cash to work, seeking out the best values available.”

Cash flow and liquidity management is not what usually comes to mind when one thinks about the components of portfolio management. “Investing is in some ways an endless process of managing liquidity.” It’s actually quite an elegant interpretation.

Diversification (when implemented effectively) assures that certain assets in the portfolio do not decline (relative to other assets) and are therefore able to be sold at attractive prices (if/when desired) with proceeds available for reinvestment. Hedges provide liquidity at the “right” time to redeploy when assets are attractively priced. Catalysts ensure duration (and cash flow) for an otherwise theoretically infinite duration equity portfolio. Duration also forces an investor to remain vigilant and alert, constantly comparing and contrasting between potential opportunities, existing holdings, and hoarding cash.

The spectrum of liquidity of different holdings within a portfolio is determined by the ability to transition between investments with minimal friction (transaction costs, wide bid-ask spread, time, etc).

“Since no investor is infallible and no investment is perfect, there is considerable merit in being able to change one’s mind…An investor who buys a nontransferable limited partnership interest or stock in a nonpublic company, by contrast, is unable to change his mind at any price; he is effectively locked in. When investors do no demand compensation for bearing illiquidity, they almost always come to regret it.

Most of the time liquidity is not of great importance in managing a long-term-oriented investment portfolio. Few investors require a completely liquid portfolio that could be turned rapidly into cash. However, unexpected liquidity needs do occur. Because the opportunity cost of illiquidity is high, no investment portfolio should be completely illiquid either. Most portfolios should maintain a balance, opting for great illiquidity when the market compensates investors well for bearing it.

A mitigating factor in the tradeoff between return and liquidity is duration. While you must always be well paid to sacrifice liquidity, the required compensation depends on how long you will be illiquid. Ten or twenty years of illiquidity is far riskier than one or two months; in effect, the short duration of an investment itself serves as source of liquidity.”

People often discuss the risk-adjusted return. However you define “risk,” it may make sense to consider a liquidity-adjusted return.

Liquidity affords you the luxury to change your mind. This not only applies to instances when you realize that you have made a mistake (preventing potential capital loss), but also helps minimize opportunity cost from not being able to invest in something “better” that materializes at a later date.

How Selective Is Too Selective?

A very smart friend and I were trading emails recently (comparing notes on a particularly hairy investment) and our conversation veered toward the issue of selectivity in an increasingly expensive and upward moving market. We reminisced about the good ol’ days (2008-2010) when fairly good businesses would trade at 5x FCF, or banks with clean balance sheets and decent ROEs were trading at 50% of book value. Whereas today, the cheap names usually come with patches of ingrown hairs. So I asked him, “Does it bother you that the market is pushing you into hairy stuff like this? Selectivity standards have obviously come down since a few years ago, but how far down are you willing to let them go?”

His answer: “I've been thinking a lot about how the market is pushing us into crappier stuff. The problem is, I think this is closer to normal. 2008 and the following years were something we get only a few times during our careers. Downturns like the summer of 2011 probably happen with more frequency. So in between, we have to figure out how to scrape together money generating ideas. I think this makes your focus on portfolio management more valuable. Portfolio construction is going to be more important.”

All too often we hear cautionary tales of selectivity & patient opportunism, but the actual implementation is far trickier. Howard Marks summed this up nicely a few months ago: “You have to learn lessons from history, but you have to learn the right lessons. The lesson can’t be that we are only going to have a portfolio that can withstand a re-run of 2008, because then you could not have much of a portfolio.” 

Perhaps the take-away here is that greed can lead to sub-optimal results in both directions. Greed in keeping your selectivity standards too high can lead to the risk of returns foregone. Greed in letting your selectivity standards slip as markets & prices move higher can lead to the risk of overloading your portfolio with unmanifested-risk and future losses.

Once again, investing forces us to delicately balance two opposing forces, which brings to mind Charlie Munger's quote: "It’s not supposed to be easy. Anyone who finds it easy is stupid."

Mind of an Achiever

In the competitive world of investing, each of us should constantly be seeking out competitive advantages. Personally, I believe that a certain degree of competitive advantage can be found in the cross-pollination of different schools of investment thought. Many in the value school often deride trading strategies, but they cannot deny the existence of those who practice the trading style of investing and have generated fantastical trackrecords over time, even if the disbelievers cannot understand the basis of how they have done so.

The following excerpts derived from Jack Schwager’s interview with Charles Faulkner in The New Market Wizards relate to trading strategies, but I think many of the psychological and process-focused aspects are also applicable to fundamental investors.

Psychology, Portfolio Management

“Natural Learning Processes [NPL]…the study of human excellence…studies great achievers to pinpoint their mental programs – that is, to learn how great achievers use their brains to product results…The key was to identify…the essence of their skills – so it could be taught to others. In NPL we call that essence a model.”

“If one person can do it, anyone else can learn to do it…Excellence and achievement have a structure that can be copied. By modeling successful people, we can learn from the experience of those who have already succeeded. If we can learn to use our brains in the same way as the exceptionally talented person, we can possess the essence of that talent.”

This is the goal of Portfolio Management Jar: to study the rationale behind portfolio management decisions of great investors, and perhaps one day generate returns the way they do. Notice, there’s a distinction between observing the actions and decisions vs. analyzing the rationale behind those actions & decisions. The true treasure trove is the latter – the way they use their brains.

Process Over Outcome, Psychology, Portfolio Management

On characteristics of successful traders:

“Another important element is that they have a perceptual filter that they know well and that they use. By perceptual filter I mean a methodology, an approach, or a system to understanding market behavior…In our research, we found that the type of perceptual filter doesn’t really make much of a difference…all these methods appear to work, provided the person knows the perceptual filter thoroughly and follows it.”

“People need to have a perceptual filter that matches the way they think. The appropriate perceptual filter for a trader has more to do with how well it fits a trader’s mental strategy, his mode of thinking and decision making, than how well it accounts for market activity. When a person gets to know any perceptual filter deeply, it helps develop his or her intuition. There’s no substitution for experience.”

Interestingly, this is very applicable to portfolio management. Because the portfolio management process has so many inputs and differs depending on the person and situation, in order to master the art of portfolio management, investors need to figure out what works for them depending on “mental strategy, his mode of thinking and decision making.” It helps to observe and analyze the thought processes of the greats who came before you, but there’s “no substitute for experience.”

Process Over Outcome, Luck, Psychology

“…if a trader does very well in one period and only average in the next, he might feel like he failed. On the other hand, if the trader does very poorly in one period, but average in the next, he’ll probably feel like he’s doing dramatically better. In either case, the trader is very likely to attribute the change of results to his system…rather than to a natural statistical tendency. The failure to appreciate this concept will lead the trader to create an inaccurate mental map of his trading ability. For example, if the trader switches from one system to another when he’s doing particularly poorly, the odds are that he’ll do better at that point in time even if the new system is only of equal merit, or possibly even if it is inferior. Yet the trader will attribute his improvement to his new system…Incidentally, the same phenomenon also explains why so many people say they do better after they have gone to a motivational seminar. When are they going to go to a motivational seminar? When they’re feeling particularly low…statistically, on average, these people will do better in the period afterwards anyway – whether or not they attended the seminar. But since they did, they’ll attribute the change to the seminar.”

“Medical science researchers take the view that the placebo effect is something bad…However, Bandler and Grinder [founders of NPL] looked at it differently. They saw the placebo effect as a natural human ability – the ability of the brain to heal the rest of the body.”

Mistakes, Process Over Outcome, Psychology

Traders seem to place a lot of value on “emotional objectivity,” a term I found interesting since it’s definitely something that’s applicable to fundamental investors especially in situations involving mistakes.

“We’ve all been in trading situations where the market moved dramatically against our position. The question is: How unsettling or disconcerting was it? What happens when you’re in a similar situation a couple of weeks or even a couple months later? If you begin to experience some of the same unsettling feelings just thinking about it, you’ve conditioned yourself just like Pavlov’s dogs.”

“Manage of one’s emotional state is critical. The truly exceptional traders can stand up to anything. Instead of getting emotional when things don’t go their way, they remain clam and act in accordance with their approach. This state of mind may come naturally. Or some people may have ways of controlling or dissipating their emotions. In either case, they know they want to be emotionally detached from feelings regarding their positions.”

Is important question is how to un-condition oneself, to remain emotionally objective when mistakes have been made. Of course, since each of us is mentally programmed differently, the answer to this question likely differs from person to person.

Psychology, Capital Preservation, Risk

“There are two different types of motivation…either toward what we want or away from what we don’t want. For example, consider how people respond to waking up in the morning…The person who wouldn’t get up until he saw images like his boss yelling at him has an ‘Away From’ motivational direction. His motivation is to get away from pain, discomfort, and negative consequences…He moves away from what he doesn’t want. The person who can’t wait to get out of bed has a ‘Toward’ motivational direction. He moves toward pleasure, rewards, goals…he moves toward what he wants. People can have both types of motivation…but most people specialize in one or the other. They are very different ways to getting motivated, and both are useful in different situations.”

“People who move toward goals are greatly valued in our society…However, the Away From direction of motivation has gotten a bad rap…The Toward motivation may be enshrined in success magazines, but the less appreciated Away From motivation individuals can also be very successful…Many outstanding traders reveal an Away From motivation when they talk about ‘protecting themselves’ or ‘playing a great defense.’ They’re only willing to take so much pain in the market before they get out. As Paul Tudor Jones said in your interview, ‘I have a short-term horizon for pain.’”

“Very often they come in with a developed Toward motivation – toward success, toward money – that’s why they got into the markets in the first place. However, those that are primarily Toward motivated must spend the time and energy to develop the Away From motivation required for proper money management. In my studies of traders I’ve found that it’s nearly impossible to be a really successful trader without the motivation to get away from excessive risk.”

Some people are more genetically inclined to focus on capital preservation. Some people are less genetically inclined to control “risk.”

Treatise on Equity Risk Premium

Howard Marks recently wrote a letter focusing almost exclusively on equities (March 2013 Letter). Within the letter, he thoroughly explores the equity risk premium – a concept usually taken for granted or as a given figure – in such a thoughtful and intuitive way, that the usually esoteric concept becomes nearly graspable by people (like me) with far less intellectual processing power.

Equity Risk Premium, Risk Free Rate

“The equity risk premium is generally defined as, “the excess return that an individual stock or the overall stock market provides over a risk-free rate.” (Investopedia) Thus it is the incremental return that investors in equities receive relative to the risk-free rate as compensation for bearing the risk involved.”

“…I strongly dislike the use of the present tense...‘The long-term equity risk premium is typically between 4.5% and 5%.’ This suggests that the premium is something that solidly exists in a fixed amount and can be counted on to pay off in the future…

The equity risk premium can actually be defined at least four different ways, I think:

1. The historic excess of equity returns over the risk-free rate.
2. The minimum incremental return that people demanded in the past to make them shift from the risk-free asset to equities.
3. The minimum incremental return that people are demanding today to make them shift away from the risk-free asset and into equities.
4. The margin by which equity returns will exceed the risk-free rate in the future.

The four uses for the term are different and, importantly, all four are applied from time to time. And I’m sure the four uses are often confused. Clearly the import of the term is very different depending on which definition is chosen. The one that really matters, in my opinion, is the fourth: what will be the payoff from equity investing. It’s also the one about which it’s least reasonable to use the word 'is,' as if the risk premium is a fact.”

“There are problems with at least three of the four meanings. Only number one can be measured…What matters for today’s investor isn’t what stocks returned in the past, or what equity investors demanded in the past or think they’re demanding today. What matters is definition number four, what relative performance will be in the future.”

“The bottom line: given that it’s impossible to say with any accuracy what return a stock or the stock market will deliver, it’s equally impossible to say what the prospective equity risk premium is. The historic excess of stock returns over the risk-free rate may tell you the answer according to definition number one, with relevance depending on which period you choose, but it doesn’t say anything about the other three…and especially not number four: the margin by which equity returns will exceed the risk-free rate in the future.”

Marks’ comments touch upon a sensitive nerve in the investment management industry. If existing calculation methods for equity risk premiums are incorrect (ahem, let’s not even get into the calculation for a “normalized forward looking” risk-free-rate), what is implication on discount rates used in so many DCF models around the world?

Alas, false precision is as dangerous as inaccuracy. But this advice doesn’t make for good analyst training manuals.

Portfolio Management

“As Einstein said, in one of my favorite quotes, ‘Not everything that counts can be counted, and not everything that can be counted counts.’”

This quote beautifully summaries why portfolio management is more art than science.

Expected Return

“To me, the answer is simple: the better returns have been, the less likely they are – all other things being equal – to be good in the future. Generally speaking, I view an asset as having a certain quantum of return potential over its lifetime. The foundation for its return comes from its ability to produce cash flow. To that base number we should add further return potential if the asset is undervalued and thus can be expected to appreciate to fair value, and we should reduce our view of its return potential if it is overvalued and thus can be expected to decline to fair value.

So – again all other things being equal – when the yearly return on an asset exceeds the rate at which it produces cash flow (or at which the cash flow grows), the excess of the appreciation over that associated with its cash flow should be viewed as either reducing the amount of its undervaluation (and thus reducing the expectable appreciation) or increasing its overvaluation (and thus increasing the price decline which is likely). The simplest example is a 5% bond. Let’s say a 5% bond at a given price below par has a 7% expected return (or yield to maturity) over its remaining life. If the bond returns 15% in the next twelve months, the expected return over its then-remaining life will be less than 7%. An above-trend year has borrowed from the remaining potential. The math is simplest with bonds (as always), but the principle is the same if you own stocks, companies or income-producing real estate.

In other words, appreciation at a rate in excess of the cash flow growth accelerates into the present some appreciation that otherwise might have happened in the future.”

A great explanation for why expected return figures should be ever forward looking, and not based on past performance.

Howard Marks' Book: Chapter 12

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 12 “The Most Important Thing Is…Finding Bargains” Definition of Investing, Portfolio Management, Position Review, Intrinsic Value, Opportunity Cost

“…‘investment is the discipline of relative selection.’” Quoting Sidney Cottle, a former editor of Graham and Dodd’s Security Analysis.

“The process of intelligently building a portfolio consists of buying the best investments, making room for them by selling lesser ones, and staying clear of the worst. The raw materials for the process consist of (a) a list of potential investments, (b) estimates of their intrinsic value, (c) a sense for how their prices compare with their intrinsic value, and (d) an understanding of the risk involved in each, and of the effect their inclusion would have on the portfolio being assembled.”

The “process of intelligently building a portfolio” doesn’t end with identifying investments, and calculating their intrinsic values and potential risks. It also requires choosing between available opportunities (because we can’t invest in everything) and anticipating the impact of inclusion upon the resulting combined portfolio of investments. Additionally, there’s the continuous monitoring of portfolio positions – comparing and contrasting between existing and potential investments, sometimes having to make room for new/better investments by “selling the lesser ones.”

It’s worthwhile to point out that intrinsic value is important not only because it tells you when to buy or sell a particular asset, but also because it serves as a way to compare & contrast between available opportunities. Intrinsic value is yet another input into the ever complicated “calculation” for opportunity cost.

Mandate, Risk

“Not only can there be risks investors don’t want to take, but also there can be risks their clients don’t want them to take. Especially in the institutional world, managers are rarely told ‘Here’s my money; do what you want with it.’”

This type of risk avoidance is a form of structural inefficiency caused by mandate restrictions. It creates opportunities for those willing to accept that particular risk and/or don’t have mandate restrictions. A great example: very few investors owned financials in 2009-2010. Fear of the “blackhole” balance sheet was only a partial explanation. During that period, I heard anecdotally that although some institutional fund managers believed the low price more than compensated for the balance sheet risk, they merely didn’t want to have to explain owning financials to their clients.

Pyschology

“…the optimism that drives one to be an active investor and the skepticism that emerges from the presumption of market efficiency must be balanced.”

Howard Marks' Book: Chapter 10

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 10 “The Most Important Thing Is…Combating Negative Influences” Mistakes, Portfolio Management, Psychology

“Why do mistakes occur? Because investing is an action undertaken by human beings, most of whom are at the mercy of their psyches and emotions. Many people possess the intellect needed to analyze data, but far fewer are able to look more deeply into things and withstand the powerful influence of psychology. To say this another way, many people will reach similar cognitive conclusions from their analysis, but what they do with those conclusions varies all over the lot because psychology influences them differently. The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.”

Marks’ comments perfectly describe why portfolio management is so difficult. The portfolio management decisions that occur after idea diligence & analysis are more art than science – intangible, manifesting differently for each person depending on his/her mental makeup. This also makes it particularly susceptible to the infiltration of psychological behavioral biases.

This underlies my assertion that merely having good ideas is not enough. In order to differentiate from the competition and to drive superior performance, investors also need to focus on portfolio management, and face the associated (and uniquely tailored) psychological obstacles.

Mistakes, Psychology

“The desire for more, the fear of missing out, the tendency to compare against others, the influence of the crowd and the dream of the sure thing – these factors are near universal. Thus they have a profound collective impact on most investors and most markets. The result is mistakes, and those mistakes are frequent, widespread and recurring.”

Howard Marks provides a few psychological factors that lead to mistakes: 

1. Greed – “Money may not be everyone’s goal for its own sake, but it is everyone’s unit of account…Greed is an extremely powerful force. It’s strong enough to overcome common sense, risk aversion, prudence, caution, logic, memory of painful past lessons, resolve, trepidation and all the other elements that might otherwise keep investors out of trouble.” 

2. Fear – “The counterpart of greed…the term doesn’t mean logical, sensible risk aversion. Rather, fear – like greed – connotes excess…more like panic. Fear is overdone concern that prevents investors from taking constructive action when they should.” 

3. Willing Suspension of Disbelief – “…people’s tendency to dismiss logic, history, and time-honored norms…Charlie Munger gave me a great quotation…from Demosthenes: ‘Nothing is easier than self-deceit. For what each man wishes, that he also believes to be true’…the process of investing requires a strong dose of disbelief…Inadequate skepticism contributes to investment losses.” I wonder, is denial then just a more extreme form of confirmation bias? 

4. Conformity/Herding Behavior – “…even when the herd’s view is clearly cockeyed…Time and time again, the combination of pressure to conform and the desire to get rich causes people to drop their independence and skepticism, overcome their innate risk aversion and believe things that don’t make sense.” 

5. Envy – “However negative the force of greed might be…the impact is even strong when they compare themselves to others…People who might be perfectly happy with their lot in isolation become miserable when they see others do better. In the world of investing, most people find it terribly hard to sit by and watch while others make more money than they do.” 

6. Ego – To a certain extent this is self-explanatory, but I will further explore this topic in another article in relation to Buffett’s concept of the “inner” vs. “outer-scorecard.” 

7. Capitulation – “…a regular feature of investor behavior late in cycles. Investors hold on to their conviction as long as they can, but when the economic and psychological pressure become irresistible, they surrender and jump on the bandwagon.” 

Psychology, When To Buy, When To Sell

“What, in the end, are investors to do about these psychological urges that push them toward doing foolish things? Learn to see them for what they are; that’s the first step toward gaining the courage to resist. And be realistic. Investors who believe they’re immune to the forces describes in this chapter do so at their own peril…Believe me, it’s hard to resist buying at the top (and harder still to sell) when everyone else is buying…it’s also hard to resist selling (and very though to buy) when the opposite is true at the bottom and holding or buying appears to entail the risk of total loss.”

Mistakes

“In general, people who go into the investment business are intelligent, educated, informed and numerate. They master the nuances of business and economics and understand complex theories. Many are able to reach reasonable confusion about value and prospects. But then psychology and crowd influences move in…The tendency toward self-doubt combines with news of other people’s successes to form a powerful force that makes investors do the wrong thing, and it gains additional strength as these trends go on longer.”

“Inefficiencies – mispricings, and misperceptions, mistakes that other people make – provide potential opportunities for superior performance. Exploiting them is, in fact, the only road to consistent outperformance. To distinguish yourself from others, you need to be on the right side of those mistakes.”

Investing is a selfish zero-sum game. Mistakes, on the part of some, must occur in order for others to generate profits. Mistakes of others = your opportunity 

Luck, Process Over Outcome

During the Tech Bubble,“Tech stock investors were lauded by the media for their brilliance. The ones least restrained by experience and skepticism – and thus making the most money – were often in their thirties, even their twenties. Never was it pointed out that they might be beneficiaries of an irrational market rather than incredible astuteness.”

Buffett Partnership Letters: 1965 Part 1

Continuation of our series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. The 1965 letter is a treasure trove of insightful portfolio management commentary from Warren Buffett. This is the Buffett for purists – the bright, candid young investor, encountering intellectual dilemmas, thinking aloud about creative solutions, and putting to paper the mental debates pulling him one direction and then another. Fascinating stuff!

Portfolio Management, Sizing, Diversification, Expected Return, Risk, Hurdle Rate, Correlation, Selectivity, Psychology

“We diversify substantially less than most investment operations. We might invest up to 40% of our net worth in a single security under conditions coupling an extremely high probability that our facts and reasoning are correct with a very low probability that anything could drastically change underlying value of the investment.

We are obviously following a policy regarding diversification which differs markedly from that of practically all public investment operations. Frankly there is nothing I would like better than to have 50 different investment opportunities, all of which have a mathematical expectation (this term reflects that range of all possible relative performances, including negative ones, adjusted for the probability of each…) of achieving performance surpassing the Dow by, say, fifteen percentage points per annum. If the fifty individual expectations were not intercorrelated (what happens to one is associated with what happens to the other) I could put 2% of our capital into each one and sit back with a very high degree of certainty that our overall results would be very close to such a fifteen percentage point advantage.

It doesn’t work that way.

We have to work extremely hard to find just a very few attractive investment situations. Such a situation by definition is one where my expectation (defined as above) of performance is at least ten percentage points per annum superior to the Dow. Among the few we do find, the expectations vary substantially. The question always is, ‘How much do I put in number one (ranked by expectation of relative performance) and how much do I put in number eight?’ This depends to a great degree on the wideness of the spread between the mathematical expectations of number one versus number eight. It also depends upon the probability that number one could turn in a really poor relative performance. Two securities could have equal mathematical expectations, but one might have 0.05 chance of performing fifteen percentage points or more worse than the Dow, and the second might have only 0.01 chance of such performance. The wide range of expectation in the first case reduces the desirability of heavy concentration in it.

The above may make the whole operation sound very precise. It isn’t. Nevertheless, our business is that of ascertaining facts and then applying experience and reason to such facts to reach expectations. Imprecise and emotionally influenced as our attempts may be, that is what the business is all about. The results of many years of decision-making in securities will demonstrate how well you are doing on making such calculations – whether you consciously realize you are making the calculations or not. I believe the investor operates at a distinct advantage when he is aware of what path his thought process is following.”

"There is one thing of which I can assure you. If good performance of the fund is even a minor objective, any portfolio encompassing one hundred stocks (whether the manager is handling one thousand dollars or one billion dollars) is not being operated logically. The addition of the one hundredth stock simply can’t reduce the potential variance in portfolio performance sufficiently to compensate for the negative effect its inclusion has on the overall portfolio expectation."

Lots of fantastic insights here. The most important take away is that, even for Buffett, portfolio management involves more art than science – it’s imprecise, requiring constant reflection, adaptation, and awareness of ones decisions and actions.

Expected Return, Trackrecord, Diversification, Volatility

“The optimum portfolio depends on the various expectations of choices available and the degree of variance in performance which is tolerable. The greater the number of selections, the less will be the average year-to-year variation in actual versus expected results. Also, the lower will be the expected results, assuming different choices have different expectations of performance.

I am willing to give up quite a bit in terms of leveling of year-to-year results (remember when I talk of ‘results,’ I am talking of performance relative to the Dow) in order to achieve better overall long-term performance. Simply stated, this means I am willing to concentrate quite heavily in what I believe to be the best investment opportunity recognizing very well that this may cause an occasional very sour year – one somewhat more sour, probably, than if I had diversified more. While this means our results will bounce around more, I think it also means that our long-term margin of superiority should be greater…Looking back, and continuing to think this problem through, I fell that if anything, I should have concentrated slightly more than I have in the past…”

Here, Buffett outlines the impact of diversification on the expected return and expected volatility of a portfolio, as well as the resulting trackrecord.

Consciously constructing a more concentrated portfolio, Buffett was willing to accept a bumpier trackrecord (more volatile returns vs. the Dow) in return for overall higher long-term returns.

To fans of this approach, I offer two points of caution:

• Increased concentration does not automatically equate to higher returns in the long-term – this is also governed by accurate security selection, or as Buffett puts it, “the various expectations of choices available”
• Notice, at this juncture in 1965-1966, Buffett has a 10-year wildly superior trackrecord. This is perhaps why short-term volatility no longer concerned him (or his clients) as much. If your fund (and client base) is still relatively new, think carefully before emulating.

Mauboussin on Portfolio Management

Michael Mauboussin, author & former Chief Investment Strategist at Legg Mason, recently joined Consuelo Mack for an interview on WealthTrack (one of my favorite resources for interesting conversations with interesting people; the transcripts are economically priced at $4.99 per episode). Their conversation touched upon a number of relevant portfolio management topics. For those of you with more time, I highly recommend listening/watching/reading the episode in its entirety. Luck, Process Over Outcome, Portfolio Management, Psychology

“MAUBOUSSIN: …luck is very important, especially for short-term results...everyone’s gotten better, and as everyone’s gotten better, skills become more uniform. There’s less variance or difference between the best and the worst. So even if luck plays the same role, lesser variance in skill means batting averages come down…So I call it the paradox of skill, because it says more skill actually leads to more luck in results…

MACK: So what are the kind of skills that we look at that would differentiate an investor from the pack, from the rest of the Street?

MAUBOUSSIN: …when you get to worlds that are probabilistic like money management where what you do, you don’t really know what the outcome is going to be, then it becomes a process and, to me, successful investing has three components to the process. The first would be analytical, and analytical to me means finding stocks for less than what they’re worth, or in the jargon means getting an investment edge, and second and related to that is putting them into the portfolio at the proper weight. So it’s not just finding good investment ideas, but it’s how you build a portfolio with those investment ideas. And by the way, a lot of people in the financial community focus on buying attractive stocks, but the structure is actually really important as well…the portfolio positioning, I think there’s room for improvement there.”           

When dealing with probabilistic predictions, such as in investing, one must focus on process, not outcome. (For more on this, be sure to check out Howard Marks’ discussion on “many futures are possible, but only one future occurs.”)

As our Readers know, PMJar seeks to emphasize the importance of portfolio management within the investment process. We are glad to see validation of this view from a premier investor such as Michael Mauboussin – that successful investing requires “not just finding good investment ideas, but how you build a portfolio with those investment ideas.”

One other corollary from the quote above – investing is a zero sum game. In order to make profits, you need to be better than the “average” market participant. But over time, ripe investment profits have lured the brightest talent from all corners of world professions and consequently, the “average” intelligence of investors has increased. This means that the qualifications necessary to reach “average” status has inconveniently increased as well.

Here’s an exercise in self-awareness: where do you fit in – below, at, or above average – versus other fellow investors?

Luck, Process Over Outcome, Sizing, Psychology

“MAUBOUSSIN: This is such an interesting question, because if you look into the future and say to people, “Hey, future outcomes are a combination of skill and luck,” everybody gets that. Right? Everybody sort of understands that’s the case, but when looking at past results, we have a much more difficult time, and I think the answer to this comes from actually neuroscience. Brain scientists have determined that there’s part of your left hemisphere in your brain which they call the interpreter, and the interpreter’s job is when it sees an effect, it makes up a cause and, by the way, the interpreter doesn’t know about skill and luck, so if it sees an effect that’s good, let’s say good results, it says, “Hey, that must be because of skill,” and then your mind puts the whole issue to rest. It just sets it aside. So we have a natural sort of module in our brain that associates good results with skill. We know it’s not always the case for the future, but once it’s done, our minds want to think about it that way.

MACK: Therefore, do we repeat, when we’ve had a success that we attribute to our skill, do we constantly repeat those same moves in order to get the same result?

MAUBOUSSIN: I think it kind of gets to one of the biggest mistakes you see in the world of investing…this is a pattern we’ve seen not only with individuals but also institutions: buying what’s hot and inversely often getting rid of what’s cold, and that ultimately is very poor for investor results. It’s about a percentage point per year reduction in long-term results for individual investors because of this effect of buying high and selling low.

…one would be over confidence. We tend to be very over confident in our own capabilities. You can show this with simple little tests, and the way that tends to show up in investing is people, when they’re projecting out into the future, they’re much more confident about the range of outcomes, so they make a very narrow range of outcomes rather than a much broader range of outcomes. So there would be one example, over confidence, and its manifestation...

...try to weave into your process tools and techniques to manage and mitigate them. I don’t think you can ever fully eradicate them, but just be aware of them and learning about them. So for example, in the over confidence, you can start to use tools to better calibrate the future, for example, using past data or making sure you’re pushing out your ranges appropriately. So there are, in every case, some tools to help you manage that."

An interesting observation on our brain’s inability to distinguish between luck vs. skill in a historical context, which explains our natural tendency to chase performance return trends.

In addition to projecting a narrow range of outcomes, overconfidence is deadly in another way – overconfidence in sizing. For example, after hitting a couple winners (mostly due to luck), an investor says “Hey, I’m really good at this. I really should have made those previous investments bigger bets. Next time.” And so, the overconfident investor sizes up the next few investments. But luck fails to appear, and the damage hurts far more because these bets were sized greater.

But worry not, salvation does exist. If investors are able to identify and become aware of their behavioral biases, they can work to control and counter the associated negative effect.

Macro

CONSUELO MACK: What’s interesting is we’ve just come through a period where we’ve heard over and over again that macro matters...I’ve had a lot of value investors come on who have very good long-term track records, saying, ‘You know what? I didn’t used to pay attention to the macro. Now I really have to pay attention. It really matters.’

MICHAEL MAUBOUSSIN: The first thing I would say about this, is this is an area of prediction that’s been very well studied, and my favorite scientist on this is a psychologist named Phil Tetlock at University of Pennsylvania who did an exhaustive study of predictions in social, political, and economic outcomes, and what he found, I think, beyond a shadow of a doubt is that experts are very poor at predicting the future. So while I know people are worries about getting whipsawed by macro events, the evidence that anybody can anticipate exactly what’s going to happen next is very, very weak. So that’s the first thing, is just to be very reserved about your belief in your ability to anticipate what’s going to happen next…Obviously, you want to be mindful of macro. I don’t want to say you be dismissive of it. I would say macro aware, but in some ways macro agnostic.”

Risk Free Rate, Equity Risk Premium

“The most interesting anomaly that I see continues to be what is high equity risk premium. So in plain words, you think of a risk-free rate of return. In the United States, a 10-year Treasury note is a good proxy for that…about a 1.8% yield. An equity risk premium is the return above and beyond that you would expect for taking on additional risk on equities. Now, over the long haul, that equity risk premium has been about three or four percent, something like that, and today, by most reckoning, it’s a lot closer to six percent. It’s very, very high.”

Historically (depending on time period examined), equity risk premium is normally 3-4%, versus ~6% today. But does this mean that today’s equity risk premium is abnormally high? Or was the historical equity risk premium just abnormally low?

What is the qualitative explanation behind the figure for the “normal” equity risk premium? Must it hold true into perpetuity?

Stanley Druckenmiller Widsom - Part 2

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.

Lisa Rapuano Interview Highlights - Part 1

Recently, I was lamenting the lack of female representation in investment management. Then in conversation, a friend reminded me of this insightful interview with Lisa Rapuano, who worked with Bill Miller for many years, and currently runs Lane Five Capital Management. The interview touches upon a number of relevant portfolio management topics. Rapuano has obviously spent hours reflecting and contemplating these topics. A worthwhile read!

Portfolio Management

“I think that most investors spend way too much time talking about stocks and way too little talking about portfolio construction.”

Expected Return, Diversification, Sizing

“I’ve learned that you have to have a lot of different risk-reward profiles in your portfolio. You’ll have some things you think can go up 25% but you don’t think can go down very much. You’ll have things that can go up 50% but might go down 30%. Others can go up ten times, but may go down 75%. I try to manage the proper mix of all those. You just can’t have a portfolio where you say everything is priced to have 25% upside with little downside. What’s going to happen is that you’re going to be wrong about two of them and they go down 50% and you’re screwed because nothing else has enough upside to make it up.”

“A word on concentration. You can take it too far. I know there are manager out there who get enthralled with the Kelly Formula and start putting out 25% or 50% positions because this one is REALLY the best. That just defies common sense. Anyone can be wrong, and any outcome can happen, even if it seems low probability. Keeping a minimum 20 name portfolio with about 5% as a normal position keeps you from making those kinds of mistakes.”

I thought the idea of maintaining a variety of expected returns in one’s portfolio was particularly interesting. People frequently discuss diversification in types of ideas/assets, but not often diversification in expected return profiles.

Also, there is wisdom in her caution against blindly using the Kelly Formula (even if you don’t agree with her advice for a 20 position portfolio). Blindly following any rule is simply a bad idea. Putting 25-50% of your portfolio into one security can be pretty painful if/when you are wrong (which happens occasionally even to the best investors).

However, that doesn’t mean one should never put 25-50% of the portfolio into one position. The important takeaway here is maintaining flexibility, being prepared (especially mentally) for the possibility that you could be wrong, and having a “break the glass” contingency plan just in case the worst materializes.

Correlation, Leverage

“We tend to run about 70-100% net long, with a maximum of 100% gross long. Since we run a very concentrated long-term fund on the long side, we believe that going over 100% gross long isn’t prudent.”

Concentration (and thus high portfolio asset correlation) and leverage is a potent combination – the result is likely in the extremes of (1) homerun good or (2) disastrously bad.

Time Management, Sizing

“A new position has to be compelling enough to put at least 3% of the fund in, or it’s not worth dabbling in.”

Howard Marks' Book: Chapter 1

In his recent book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Howard Marks of Oaktree writes about a lot of different investment topics. I’ve done my best to lift out relevant portfolio management details. Without further ado, below are highlights from Chapter 1, titled “The Most Important Thing Is…Second-Level Thinking.” Portfolio Management

“Because investing is at least as much art as it is science, it’s never my goal – in this book or elsewhere – to suggest it can be routinized. In fact, one of the things I most want to emphasize is how essential it is that one’s investment approach be intuitive and adaptive rather than be fixed and mechanistic.”

Successful investing involves equal parts sniffing out ideas, effective diligence, and thoughtful portfolio management. Marks’ comments may not have been written to pertain specifically to the portfolio management process, but it certainly applies.

It’s difficult to routinize portfolio management since the process differs by person and by strategy. Tug on one side of the intricate web and you change the outcome in several other areas. Portfolio management, like the “investing” in Marks’ words, is an art, not the science – distilled into a perfectly eloquent formula or model as many academics and theorists have attempted to extract. (Ironically, Howard Marks and I were both educated at the University of Chicago.) Art demands some degree of inherent messiness – constant changes, tweaks, paint everywhere. Art, like portfolio management, requires practice, dedication, and reflection over time.

Creativity

“No rule always works…An investment approach may work for a while, but eventually the actions it calls for will change the environment, meaning a new approach is needed. And if others emulate an approach, that will blunt its effectiveness.”

“Unconventionality shouldn’t be a goal in itself, but rather a way of thinking. In order to distinguish yourself from others, it helps to have ideas that are different and to process those ideas differently.”

Investment performance is ever forward looking. A strategy or idea that’s worked in the past may or may not provide the same success in the future. Marks’ comments regarding the importance of creativity have broad applications – from idea sourcing to the diligence process to portfolio management technique.

Maintaining that creative spirit, staying one step ahead of the competition (sounds oddly like running a business, doesn’t it?) is crucial to generating superior investment returns over the long run.

Definition of Investing, Benchmark

“In my view, that’s the definition of successful investing: doing better than the market and other investors.”

Here, the definition of successful investing depends upon “doing better than” a certain “market” or “other investors.”

In order to “do better” than something, an investor must identify that something ahead of time – whether it be a single market index or a bundle of indices and other competing funds.

We’ve discussed the topic of benchmarks in the past (see benchmark tag). For example, during the Partnership days, Buffett used the Dow as his primary benchmark, but also showed investors his performance against a group of well-known mutual and closed end funds. Some Brazilian hedge funds use the local risk-free-rate as their benchmark.

The point is: your choice of benchmark can vary, just make sure that you’ve at least made a choice.