Soros’ Alchemy – Chapter 4

Seth Klarman of Baupost wrote in a 1996 Letter that one should always be cognizant of whether seemingly different investments are actually the same bet in order to avoid risk of concentrated exposures. In other words, the task of risk management involves identifying (and if necessary, neutralizing) common risks underlying different portfolio holdings. One such "common denominator" risk that comes to mind (in today's yield-hungry environment) is the availability of credit and its impact on asset and collateral values, which in turn greatly influences returns available to investors holding different securities across the capital structure. Below are some musing on the topic of credit reflexivity / boom and bust cycles from George Soros, derived from his book Alchemy of Finance – Chapter 4: The Credit and Regulatory Cycle.

Macro, Intrinsic Value, Psychology, Risk

“…special affinity between reflexivity and credit. That is hardly surprising: credit depends on expectations; expectations involve bias; hence credit is one of the main avenues that permit bias to play a causal role in the course of events…Credit seems to be associated with a particular kind of reflexive pattern that is known as boom and bust. The pattern is asymmetrical: the boom is drawn out and accelerates gradually; the bust is sudden and often catastrophic…

I believe the asymmetry arises out of a reflexive connection between loan and collateral. In this context I give collateral a very broad definition: it will denote whatever determines the creditworthiness of a debtor, whether it is actually pledged or not. It may mean a piece of property or an expected future stream of income; in either case, it is something on which the lender is willing to place a value. Valuation is supposed to be a passive relationship in which the value reflects the underlying asset; but in this case it involves a positive act: a loan is made. The act of lending may affect the collateral value: that is the connection that gives rise to a reflexive process.”

“The act of lending usually stimulates economic activity. It enables the borrower to consume more than he would otherwise, or to invest in productive assets...By the same token, debt service has a depressing impact. Resources that would otherwise be devoted to consumption or the creation of a future stream of income are withdrawn. As the total amount of debt outstanding accumulates, the portion that has to be utilized for debt service increases."

“In the early stages of a reflexive process of credit expansion the amount of credit involved is relatively small so that its impact on collateral values is negligible. That is why the expansionary phase is slow to start with and credit remains soundly based at first. But as the amount of debt accumulates, total lending increases in importance and begins to have an appreciable effect on collateral values. The process continues until a point is reached where total credit cannot increase fast enough to continue stimulating the economy. By that time, collateral values have become greatly dependent on the stimulative effect of new lending and, as new lending fails to accelerate, collateral values begin to decline. The erosion of collateral values has a depressing effect on economic activity, which in turn reinforces the erosion of collateral values. Since the collateral has been pretty fully utilized at that point, a decline may precipitate the liquidation of loans, which in turn may make the decline more precipitous. That is the anatomy of a typical boom and bust.

Booms and busts are not symmetrical because, at the inception of a boom, both the volume of credit and the value of the collateral are at a minimum; at the time of the bust, both are at a maximum. But there is another factor at play. The liquidation of loans takes time; the faster it has to be accomplished, the greater the effect on the value of the collateral. In a bust, the reflexive interaction between loans and collateral becomes compressed within a very short time frame and the consequences can be catastrophic. It is the sudden liquidation of accumulated positions that gives a bust such a different shape from the preceding boom.

It can be seen that the boom/bust sequence is a particular variant of reflexivity. Booms can arise whenever there is a two-way connection between values and the act of valuation. The act of valuation takes many forms. In the stock market, it is equity that is valued; in banking, it is collateral.”

“Busts can be very disruptive, especially if the liquidation of collateral causes a sudden compression of credit. The consequences are so unpleasant that strenuous efforts are made to avoid them. The institution of central banking has evolved in a continuing attempt to prevent sudden, catastrophic contractions in credit. Since a panic is hard to arrest once it has started, prevention is best practiced in the expansionary phase. That is why the role of central banks has gradually expanded to include the regulation of the money supply. That is also why organized financial markets regulate the ratio of collateral to credit.”

“Financial history is best interpreted as a reflexive process in which there are two sets of participants instead of one: competitors and regulators…It is important to realize that the regulators are also participants. There is a natural tendency to regard them as superhuman beings who somehow stand outside and above the economic process and intervene only when the participants have made a mess of it. That is not the case. They also are human, all too human. They operate with imperfect understanding and their activities have unintended consequences.”

BlueCrest’s Michael Platt

Michael Platt and BlueCrest Capital have been in the headlines recently as the latest hedge fund billionaire to return external capital and morph into a private partnership / family office. Below are portfolio management tidbits from Platt's interview with Jack Schwager in Hedge Fund Market Wizards. Capital Preservation, Risk, Team Management

“I have no appetite for losses. Our discretionary strategy’s worst peak-to-trough drawdown in over 10 years was less than 5 percent, and this strategy lost approximately 5 percent in one month. One thing that brings my blood to a boiling point is when an absolute return guy starts talking about his return relative to anything. My response was, ‘You are not relative to anything, my friend. You can’t be in the relative game just when it suits you and in the absolute game just when it suits you. You are in the absolute return game, and the fact that you use the word relative means that I don’t want you anymore.’”

“The risk control is all bottom-up. I structured the business right from the get-go so that we would have lots of diversification. For example, on the fixed income side, I hire specialists. I have a specialist in Scandinavian rates, a specialist in the short end, a specialist in volatility surface arbitrage, a specialist in euro long-dated trading, an inflation specialist, and so on. They all get a capital allocation. Typically, I will hand out about $1.5 billion for every $1 billion we manage because people don’t use their entire risk allocation all the time. I assume, on average, they will use about two thirds. The deal is that if a trader loses 3 percent, he has to give me back half of his trading line. If he loses another 3 percent of the remaining half, that’s it. His book is auctioned. All the traders are shown his book and take what they want into their own books, and anything that is left is liquidated.”

“Q: What happens to the trader at that point? Is he out on the street? A: It depends on how he reached his limit. I’m not a hard-nosed person. I don’t say, you lost money, get out. It’s possible someone gets caught in a storm. A trader might have some very reasonable Japanese positions on, and then there is a nuclear accident, and he loses a lot of money. We might recapitalize him, but it depends. It is also a matter of gut feel. How do I feel about the guy?

Q: Is the 3 percent loss measured from the allocation starting level? A: Yes, it is definitely not a trailing stop. We want people to scale down if they are getting it wrong and scale up if they are getting it right. If a guy has a $100 million allocation and makes $20 million, he then has $23 million to his stop point.

Q: Do you move that stop up at any point? A: No, it rebases annually.

Q: So every January 1, traders start off with the same 3 percent stop point? A: Yes, unless they carry over some of their P&L. One year, one of my guys made about $500 million of profits. He was going to get a huge incentive check. I said to him, ‘Do you really want to be paid out on the entire $500 million? How about I pay you on $400 million, and you carry over $100 million, so you still have a big line.’ He said, ‘Yeah, that’s cool. I’ll do that.’ So he would have to lose that $100 million plus 3 percent of the new allocation before the first stop would kick in.”

“I don’t interfere with traders. A trader is either a stand-alone producer or gone. If I start micromanaging a trader’s position, it then becomes my position. Why then am I paying him such a large percentage of the incentive fee?”

“We have a seven-person risk management team…The key thing they are monitoring for is a breakdown in correlation…because most of our positions are spreads. So lower correlations would increase the risk of the position. The most dangerous risks are spread risks. If I assume that IBM and Dell have a 0.95 correlation, I can put on a large spread position with relatively small risk. But if the correlation drops to 0.50, I could be wiped out in 10 minutes. It is when the spread risks blow up that you find out that you have much more risk than you thought.

Controlling correlations is the key to managing risk. We look at risk in a whole range of different ways…They stress test the positions for all sorts of historical scenarios. They also scan portfolios to search for any vulnerabilities in positions that could impact performance. They literally ask the traders, ‘If you were going to drop $10 million, where would it come from?’ And the traders will know. A trader will often have some position in his book that is a bit spicy, and he will know what it is. So you just ask him to tell you. Most of what we get in the vulnerabilities in positions reports, we already know anyway. We would hope that our risk monitoring systems would have caught 95 percent of it. It is just a last check.”

Creativity, Psychology

“The type of guy I don’t want is an analyst who has never traded—the type of person who does a calculation on a computer, figures out where a market should be, puts on a big trade, gets caught up in it, and doesn’t stop out. And the market is always wrong; he’s not…

I look for the type of guy in London who gets up at seven o’clock on Sunday morning when his kids are still in bed, and logs onto a poker site so that he can pick off the U.S. drunks coming home on Saturday night. I hired a guy like that. He usually clears 5 or 10 grand every Sunday morning before breakfast taking out the drunks playing poker because they’re not very good at it, but their confidence has gone up a lot. That’s the type of guy you want —someone who understands an edge. Analysts, on the other hand, don’t think about anything else other than how smart they are.”

“I want guys who when they put on a good trade immediately start thinking about what they could put on against it. They just have the paranoia. Market makers get derailed in crises far less often than analysts. I hired an analyst one time who was a very smart guy. I probably made 50 times more money on his ideas than he did. I hired an economist once, which was the biggest mistake ever. He lasted only a few months. He was very dogmatic. He thought he was always right. The problem always comes down to ego. You find that analysts and economists have big egos, which just gets in the way of making money because they can never admit that they are wrong.”

“Both the ex-market makers who blew up became way too invested in their positions. Their ego got in the way. They just didn’t want to be wrong, and they stayed in their positions.”

Psychology, Opportunity Cost, Mistake

“I don’t have any tolerance for trading losses. I hate losing money more than anything. Losing money is what kills you. It is not the actual loss. It’s the fact that it messes up your psychology. You lose the bullets in your gun. What happens is you put on a stupid trade, lose $20 million in 10 minutes, and take the trade off. You feel like an idiot, and you’re not in the mood to put on anything else. Then the elephant walks past you while your gun’s not loaded. It’s amazing how annoyingly often that happens. In this game, you want to be there when the great trade comes along. It’s the 80/20 rule of life. In trading, 80 percent of your profits come from 20 percent of your ideas.”

“…I look at each trade in my book every day and ask myself the question, 'Would I enter this trade today at this price?' If the answer is 'no,' then the trade is gone.”

“When I am wrong, the only instinct I have is to get out. If I was thinking one way, and now I can see that it was a real mistake, then I am probably not the only person in shock, so I better be the first one to sell. I don’t care what the price is. In this game, you have an option to keep 20 percent of your P&L this year, but you also want to own the serial option of being able to do that every year. You can’t be blowing up.”

How many of us have been in a situation when we were busy putting out fire(s) on existing position(s) when we should have been focused on new/better ideas?

Exposure

“I like buying stuff cheap and selling it at fair value. How you implement a trade is critical. I develop a macro view about something, but then there are 20 different ways I can play it. The key question is: which way gives me the best risk/return ratio? My final trade is rarely going to be a straight long or short position.”

His core goal is not all that different from what fundamental investors are try to achieve: buy cheap, sell a fair or higher value. The main difference stems from how the bets are structured and the exposures created.

Creativity, Diversification, Correlation 

“I have always liked puzzles…I always regarded financial markets as the ultimate puzzle because everyone is trying to solve it, and infinite wealth lies at the end of solving it."

“Currently, because of the whole risk-on/risk-off culture that has developed, diversification is quite hard to get. When I first started trading about 20 years ago, U.S. and European bond markets weren’t really that correlated. Now, these markets move together tick by tick.”

“The strategy is always changing. It is a research war. Leda has built a phenomenal, talented team that is constantly seeking to improve our strategy.”

Markets are a zero sum game less transaction costs. Participants / competitors are constantly shifting and changing their approach to one-up each other because there is infinite wealth involved. What worked yesterday may not work today or tomorrow. Historical performance is not indicative of future result. This is also why so many quantitative frameworks for diversification and correlation that use historical statistics are so flawed. Investors must constantly improve and adapt to current and future conditions. Otherwise someone else will eat your lunch.

Whitebox on Risk & Risk Management

There must be something in the Whitebox water supply: it's producing an army of investment math nerds with acute self-awareness and sensibilities, led by their fearless leader Andy Redleaf. Those of you who have not yet seen Whitebox's "10 Enduring Principles To Interpret Constant Market Change" are missing out -- it is absolutely worth three minutes of your day. The text below is extracted from a Jan 2015 Andy Redleaf article titled "Getting Past the Romance of Risk":

“The courage to ‘take a chance.’ The fearlessness of being a ‘risk taker.’ Risk as the force of entrepreneurship. These ideas are so ingrained in the American psyche that in the investment industry they have become dogma: to increase returns the investor must be willing to accept more risk. That is the core result of Modern Portfolio Theory, even if it is hedged with theories about how to accept risk systematically on the “efficient frontier.”

Given this persistent quasi-romance with risk, we have to ask: What great investor or entrepreneur ever succeeded by deliberately taking on more risk?

...the entrepreneur’s goal should always be to create asymmetries of risk and reward in which there is far more to be gained than lost. We strongly believe all investment managers should be doing the same, which is why the first of Whitebox’s 10 Investment Principles is: The source of investment return is the efficient reduction of risk.

If risk is not the basis of return, should an investor strive to take no risk at all? No. There is no such thing as a risk-free portfolio. We believe that the right goal is to reduce risk efficiently: reduce the risks of a position more than one reduces its potential return. One can do this in various ways, but it comes down to the investor striving to own only and exactly what he wants to own…

How do we believe an investor can own only and exactly what he wants to own? In practical terms, what does this look like?

In reality, most securities, taken individually, are bundles of both good and bad qualities. Even a stock that presents generally favorable prospects for potentially good returns is likely to contain at least some unfavorable qualities; the same is generally true for bonds. As such, we believe the key – and the whole point of alternative investing – is to be able to identify and isolate the good from the bad, so that you own only and exactly what you want.

How is this achieved? Sometimes this is done at the security level, by buying securities with desirable qualities and canceling out the undesirable qualities through carefully constructed positions in our short book. Sometimes it is done at the portfolio level, by combining investment “themes” in ways that retain the attractive qualities of an investment idea while, hopefully, canceling out the risks.

Sometimes, it can be achieved by striving to identify and implement hedges that are in themselves what we perceive as sound, attractive investments, the goal being to reduce risk through tactics and decisions that are themselves potentially return-generating investments…

Viewing risk-reduction in itself as a source of potential returns is in stark contrast to a more traditional approach, which we believe accepts some measure of loss in exchange for potential payoff.

Exercising sound judgment in investing, we believe, involves choosing the particular over the abstract. This can mean the difference between buying up “lots” of securities in bundles (often to satisfy a predetermined allocation percentage, for example) versus sorting through individual names, looking for nuances lurking beyond-the-obvious that enhance value, and identifying idiosyncratic dislocations – even among securities that are bought and sold in “lots.” It means looking at risk specifically, not from a high level of abstraction, striving to reduce that risk efficiently through a hedge that in itself is an investment with potential payoff.

Put another way, we believe efficient reduction of risk begins with and cannot be separated from the investment process. To us, every investment decision, therefore, should be a decision about risk. We reject the concept of risk management as an “overlay.”

Most of all, we believe this investment principle entails viewing risk and risk mitigation as a matter of judgment. We feel confident in our belief that investors who exercise good judgment are more likely to prosper than investors who do not…

Seen from this perspective, the concept of risk is somewhat reframed. We simply reject the idea that says “the greater the risk, the greater potential for return.” To us, a truly alternative approach to investing involves what we believe to be a fairly straightforward endeavor: efficiently reduce risk so as to own only and exactly what you want to own.”

On efficient markets: “We believe this…approach to investing isn’t safe, mostly because we see it as lazy. On every point listed above, we’re convinced that money managers who go along with these dogmas are saving themselves work, but risking investors’ money.”

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.

Howard Marks' Book: Chapter 19

This concludes our series on portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 19 “The Most Important Thing Is…Adding Value” Trackrecord, Compounding, Capital Preservation

“It means relatively little that a risk taker achieves a high return in a rising market, or that a conservative investors is able to minimize losses in a decline. The real question is how they do in the long run and in climates for which their style is ill suited…Without skill, aggressive investors move a lot in both directions, and defensive investors move little in either direction…

Aggressive investors with skill do well in bull markets but don’t’ give it all back in corresponding bear markets, while defensive investors with skill lose relatively little in bear markets but participate reasonably in bull markets. Everything in investing is a two-edged sword and operates symmetrically, with the exception of superior skill.”

“The performance of investors who add value is asymmetrical. The percentage of the market’s gain they capture is higher than the percentage of loss they suffer…Only skill can be counted on to add more in propitious environments than it costs in hostile ones. This is the investment asymmetry we seek.”

“In good years in the market, it’s good enough to be average. Everyone makes money in the good years...There is a time, however, when we consider it essential to beat the market, and that’s in the bad years…it’s our goal to do as well as the market when it does well and better than the market when it does poorly. At first blush that may sound like a modest goal, but it’s really quite ambitious. In order to stay up with the market when it does well, a portfolio has to incorporate good measure of beta and correlation with the market. But if we’re aided by beta and correlation on the way up, shouldn’t they be expected to hurt us on the way down? If we’re consistently able to decline less when the market declines and also participate fully when the market rises, this can be attributable to only one thing: alpha, or skill…Asymmetry – better performance on the upside than on the downside relative to what our style alone would produce – should be every investor’s goal.”

For more on the topic of asymmetry, be sure to check out our article titled “Asymmetry Revisited”

Volatility

“A portfolio with a beta above 1 is expected to be more volatile than the reference market, and a beta below 1 means it’ll be less volatile. Multiply the market return by the beta and you’ll get the return that a given portfolio should be expected to achieve…If the market is up 15 percent, a portfolio with a beta of 1.2 should return 18 percent (plus or minus alpha).”

We often find common threads between different investors. For example, there is evidence that Buffett was thinking about expected beta as early as the 1950s and 1960s (back in the day when he did not have permanent capital) -- see our articles on Buffett Partnership Letters and Volatility.

Expected Return, Risk

“Although I dismiss the identity between risk and volatility, I insist on considering a portfolio’s return in the light of its overall riskiness…A manager who earned 18 percent with a risky portfolio isn’t necessarily superior to one who earned 15 percent with a lower-risk portfolio. Risk-adjusted return holds the key, even though – since risk other than volatility can’t be quantified – I feel it is best assessed judgmentally, not calculated scientifically.”

“‘beating the market’ and ‘superior investing’ can be far from synonymous…It’s not just your return that matters, but also what risk you took to get it…”

Opportunity Cost, Benchmark

“…all equity investors start not with a blank sheet of paper but rather with the possibility of simply emulating an index...investors can decide to deviates from the index in order to exploit their stock-picking ability…In doing so they will alter the exposure of their portfolio to…price movements that affect only certain stocks, not the index…their return will deviate as well."

We are all faced with this choice that, at a minimum, we can emulate an index. If we choose not to, it’s because we believe we can generate outperformance via higher returns and same risk, similar returns at lower risk, or higher returns at lower risk. If we cannot accomplish any of the above, then we have failed to do better than an index (and failed to add value as investors). But if we did not have an index or benchmark against which to measure progress, how would we know whether we have succeeded or failed?

Howard Marks' Book: Chapter 18

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 18 “The Most Important Thing Is…Avoiding Pitfalls” Risk, Volatility

“…trying to avoid losses is more important than striving or great investment successes. The latter can be achieved some of the time, but the occasional failures may be crippling. The former can be done more often and more dependably…and with consequences when it fails that are more tolerable…A portfolio that contains too little risk can make you underperform in a bull market, but no one ever went bust from that; there are far worse fates.”

“You could require your portfolio to do well in a rerun of 2008, but then you’d hold only Treasurys, cash and gold. Is that a viable strategy? Probably not. So the general rule is that it’s important to avoid pitfalls, but there must be a limit. And the limit is different for each investor.”

Volatility, Psychology, Trackrecord, When To Buy, When To Sell, Clients

“…almost nothing performed well in the meltdown of 2008…While it was nigh onto impossible to avoid declines completely, relative outperformance in the form of smaller losses was enough to let you do better in the decline and take grater advantage of the rebound.”

“In periods that are relatively loss free, people tend to think of risk as volatility and become convinced they can live with it. If that were true, they would experience markdowns, invest more at the lows and go on to enjoy the recovery, coming out ahead in the long run. But if the ability to live with volatility and maintain one’s composure has been overestimated—and usually it has—that error tends to come to light when the market is a its nadir. Loss of confidence and resolve can cause investors to sell at the bottom, converting downward fluctuations into permanent losses and preventing them from participating fully in the subsequent recovery. This is the great error in investing—the most unfortunate aspect of pro-cyclical behavior—because of its permanence and because it tends to affect large portions of portfolios.”

“While it’s true that you can’t spend relative outperformance, human nature causes defensive investors and their less traumatized clients to derive comfort in down markets when they lose less than others. This has two very important effects. First, it enables them to maintain their equanimity and resist the psychological pressures that often make people sell at lows. Second, being in a better frame of mind and better financial condition, they are more able to profit from the carnage by buying at lows. Thus, they generally do better in recoveries.”

Volatility is not the true risk; the true risk lies in what investors do / how they behave during volatile periods.

Mistakes, Creativity, Psychology

“One type of analytical error…is what I call ‘failure of imagination’…being unable to conceive of the full range of possible outcomes or not fully understanding the consequences of the more extreme occurrences.”

“Another important pitfall…is the failure to recognize market cycles and manias and move in the opposite direction. Extremes in cycles and trends don’t occur often, and thus they’re not a frequent source of error, but they give rise to the largest errors.”

“…when the future stops being like the past, extrapolation fails and large amounts of money are either lost or not made…the success of your investment actions shouldn’t be highly dependent on normal outcomes prevailing; instead, you must allow for outliers…"

“…the third form of error doesn’t consist of doing the wrong thing, but rather of failing to do the right thing. Average investors are fortunate if they can avoid pitfalls, whereas superior investors look to take advantage of them…a different kind of mistake, an error of omission, but probably one most investors would be willing to live with.”

“The essential first step in avoiding pitfalls consists of being on the lookout for them…learning about pitfalls through painful experience is of only limited help. The key is to try to anticipate them…The markets are a classroom where lesson are taught every day. The keys to investment success lie in observing and learning.”

“The fascinating and challenging thing is that the error moves around. Sometimes prices are too high and sometimes they’re too low. Sometimes the divergence of prices from value affects individual securities or assets and sometimes whole markets – sometimes one market and sometimes another. Sometimes the error lies in doing something and sometimes in not doing it, sometimes in being bullish and sometimes in being bearish…avoiding pitfalls and identifying and acting on error aren’t susceptible to rules, algorithms, or roadmaps. What I would urge is awareness, flexibility, adaptability and a mind-set that is focused on taking cues from the environment.”

Correlation, Diversification, Risk

“There’s another important aspect of failure of imagination. Everyone knows assets have prospective returns and risks, and they’re possible to guess at. But few people understand asset correlation: how one asset will react to a change in another, or that two assets will react similarly to a change in a third. Understanding and anticipating the power of correlation – and thus the limitations of diversification – is a principal aspect of risk control and portfolio management, but it’s very hard to accomplish…Investors often fail to appreciate the common threads that run through portfolios.”

“Hidden fault lines running through portfolios can make the prices of seemingly unrelated assets move in tandem. It’s easier to assess the return and risk of an investment than to understand how it will move relative to others. Correlation is often underestimated, especially because of the degree to which it increases in crisis. A portfolio may appear to be diversified as to asset class, industry and geography, but in tough times, non-fundamental factors such as margin calls, frozen markets and a general risk in risk aversion can become dominant, affecting everything similarly.”

Hedging, Expected Return, Opportunity Cost, Fat Tail

“…a dilemma we have to navigate. How much time and capital should an investor devote to protecting against the improbable disaster? We can insure against every extreme outcome…But doing so will be costly, and the cost will detract form investment returns when that protection turns out not to have been needed…and that’ll be most of the time.”

Howard Marks’ Book: Chapter 17

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 17 “The Most Important Thing Is…Investing Defensively” -- a rather apt topic given today's market environment. Psychology, Capital Preservation, Expected Return, Risk, Opportunity Cost

“What’s more important to you: scoring points or keeping your opponent from doing so? In investing, will you go for winners or try to avoid losers? (Or, perhaps more appropriately, how will you balance the two?) Great danger lies in acting without having considered these questions.

And by the way, there’s no right choice between offense and defense. Lots of possible routes can bring you to success, and your decision should be a function of your personality and leanings, the extent of your belief in your ability, and the peculiarities of the markets you work in and the clients you work for.”

“Like everything in investing, this isn’t a matter of black and white. The amount of risk you’ll bear is a function of the extent to which you choose to pursue return. The amount of safety you build into your portfolio should be based on how much potential return you’re willing to forego. There’s no right answer, just trade-offs…Because ensuring the ability to survive under adverse circumstances is incompatible with maximizing returns in the good times, investors must choose between the two.” 

Are capital preservation (defense, avoiding losers, etc.) & expected return (offense, going for winners, etc.) mutually exclusive concepts? Perhaps in the short-run, but in the long-run, they are two side of the same coin. Avoiding loss is essential to capital compounding over time. This is because the effects of compounding math are not symmetrical. A 50% loss in one period requires a 100% in a subsequent period just to break even! See our previous article titled: “Asymmetry Revisited” for more on the interplay between capital preservation and compounding.

Capital Preservation, Volatility, Diversification, Leverage

“But what’s defense? Rather than doing the right thing, the defensive investor’s main emphasis is on not doing the wrong thing.

Is there a difference between doing the right thing and avoiding doing the wrong thing? On the surface, they sound quite alike. But when you look deeper, there’s a big difference between the mind-set needed for one and the mind-set needed for the other, and a big difference in the tactics to which the two lead.

While defense may sound like little more than trying to avoid bad outcomes, it’s not as negative or non-aspirational as that. Defense actually can be seen as an attempt at higher returns, but more through the avoidance of minuses than through the inclusion of pluses, and more through consistent but perhaps moderate progress than through occasional flashes of brilliance.

There are two principal elements in investment defense. The first is the exclusion of losers from portfolios…and being less willing to bet on continued prosperity, and rosy forecasts and developments that may be uncertain. The second element is the avoidance of poor years and, especially, exposure to meltdown in crashes…this aspect of investment defense requires thoughtful portfolio diversification, limits on the overall riskiness borne, and a general tilt toward safety.

Concentration (the opposite of diversification) and leverage are two examples of offense. They’ll add to returns when they work but prove harmful when they don’t: again the potential for higher highs and lower lows from aggressive tactics. Use enough of them, however, and they can jeopardize your investment survival if things go awry. Defense, on the other hand, can increase your likelihood of being able to get through the tough times and survive long enough to enjoy the eventual payoff from smart investments.”

Psychology, Luck, Process Over Outcome

“The choice between offense and defense investing should be based on how much the investor believes is within his or her control…But investing is full of bad bounces and unanticipated developments…The workings of economies and markets are highly imprecise and variable, and the thinking and behavior of the other players constantly alter the environment…investment results are only partly within the investors’ control…The bottom line is that even highly skilled investors can be guilty of mis-hits, and the overaggressive shot can easily lose them the match.”

“Playing for offense – trying for winners through risk bearing – is a high octane activity. It might bring the gains you seek…or pronounced disappointment. And there’s something else to think about: the more challenging and potentially lucrative the waters you fish in, the more likely they are to have attracted skilled fishermen. Unless your skills render you fully competitive, you’re more likely to be prey than victor. Playing offense, bearing risk and operating in technically challenging fields mustn’t be attempted without the requisite competence.”

Psychology plays an integral role in successful investing. One must learn to distinguish between the impact of process (avoiding the mis-hits) vs. the outcome (sometimes uncontrollable), and to not be deterred by the occasional but inevitable “bad bounce.” Additionally, there’s the self-awareness and honesty requirement so that one can exercise discipline and remove oneself from the game if/when necessary.

Psychology, Trackrecord

“Investing is a testosterone-laden world where too many people think about how good they are and how much they’ll make if the swing for the fences and connect. Ask some investors of the ‘I know’ school to tell you what makes them good, and you’ll hear a lot abut home runs they’ve hit in the past the home runs-in-the-making that reside in their current portfolio. How many talk about consistency, or the fact that their worst year wasn’t too bad.”

“One of the most striking things I’ve noted over the last thirty-five years is how brief most outstanding investment careers are. Not as short as the careers of professional athletes, but shorter than they should be in a physically nondestructive vocation.

Where’d they go? Many disappeared because organizational flaws render their game plans unsustainable. And the rest are gone because they swung for the fences but struck out instead.

That brings up something that I consider a great paradox: I don’t think many investment managers’ careers end because they fail to hit home runs. Rather, they end up out of the game because they strike out too often – not because they don’t have enough winners, but because they have too many losers. And yet, lots of managers keep swinging for the fences.”

“Personally, I like caution in money managers. I believe that in many cases, the avoidance of losses and terrible years is more easily achievable than repeated greatness, and thus risk control is more likely to create a solid foundation for a superior long-term trackrecord.”

Related to the above, please see our previous articles on the concepts of “Toward vs. Away-From Motivation” and “Outer vs. Inner Scorecard.”

Baupost Letters: 2000-2001

This concludes our series on portfolio management and Seth Klarman, with ideas extracted from old Baupost Group letters. Our Readers know that we generally provide excerpts along with commentary for each topic. However, at the request of Baupost, we will not be providing any excerpts, only our interpretive summaries. For those of you wishing to read the actual letters, they are available on the internet. We are not posting them here because we don’t want to tango with the Baupost legal machine.

Volatility, Psychology

Even giants are not immune to volatility. Klarman relays the story of how Julian Robertson’s Tiger Fund closed its doors largely as a result of losses attributed to its tech positions. As consolation, Klarman offers some advice on dealing with market volatility: investors should act on the assumption that any stock or bond can trade, for a time, at any price, and never enable Mr. Market’s mood swings to lead to forced selling. Since it is impossible to predict the timing, direction and degree of price swings, investors would do well to always brace themselves for mark to market losses.

Does mentally preparing for bad outcomes help investors “do the right thing” when bad outcomes occur? 

When To Buy, When To Sell, Selectivity

Klarman outlines a few criteria that must be met in order for undervalued stocks to be of interest to him:

• Undervaluation is substantial
• There’s a catalyst to assist in the realization of that value
• Business value is stable and growing, not eroding
• Management is able and properly incentivized

Have you reviewed your selectivity standards lately? How do they compare with three years ago? For more on this topic, see our previous article on selectivity. 

Psychology, When To Buy, When To Sell

Because investing is a highly competitive activity, Klarman writes that it is not enough to simply buy securities that one considers undervalued – one must seek the reason for why something is undervalued, and why the seller is willing to part with a security/asset at a “bargain” price.

Here’s the rub: since we are human and prone to psychological biases (such as confirmation bias), we can conjure up any number of explanations for why we believe something is undervalued and convince ourselves that we have located the reason for undervaluation. It takes a great degree of cognitive discipline & self awareness to recognize and concede when you are (or could be) the patsy, and to walk away from those situations.

Risk, Expected Return, Cash

Klarman’s risk management process was not after-the-fact, it was woven into the security selection and portfolio construction process.

He sought to reduce risk on a situation by situation basis via

• in-depth fundamental analysis
• strict assessment of risk versus return
• demand for margin of safety in each holding
• event-driven focus
• ongoing monitoring of positions to enable him to react to changing market conditions or fundamental developments
• appropriate diversification by asset class, geography and security type, market hedges & out of the money put options
• willingness to hold cash when there are no compelling opportunities.

Klarman also provides a nice explanation of why undervaluation is so crucial to successful investing, as it relates to risk & expected return: “…undervaluation creates a compelling imbalance between risk and return.”

Benchmark

The investment objective of this particular Baupost Fund was capital appreciation with income was a secondary goal. It sought to achieve its objective by profiting from market inefficiencies and focusing on generating good risk-adjusted investment results over time – not by keeping up with any particular market index or benchmark. Klarman writes, “The point of investing…is not to have a great story to tell; the point of investing is to make money with limited risk.”

Investors should consider their goal or objective for a variety of reasons. Warren Buffett in the early Partnership days dedicated a good portion of one letter to the “yardstick” discussion. Howard Marks has referenced the importance of having a goal because it provides “an idea of what’s enough.”

Cash, Turnover

Klarman presents his portfolio breakdown via “buckets” not individual securities. See our article on Klarman's 1999 letter for more on the importance of this nuance. 

The portfolio allocations changed drastically between April 1999 and April 2001. High turnover is not something that we generally associate with value-oriented or fundamental investors. In fact, turnover has quite a negative connotation. But is turnover truly such a bad thing?

Munger once said that “a majority of life’s errors are caused by forgetting what one is really trying to do.”

Yes, turnover can lead to higher transaction fees and realized tax consequences. On taxes, we defer to Buffett’s wonderfully crafted treatise on his investment tax philosophy from 1964, while the onset of electronic trading has significantly decreased transaction fees (specifically for equities) in recent days.

Which leads us back to our original question: is portfolio turnover truly such a bad thing? We don’t believe so. Turnover is merely the consequence of portfolio movements triggered by any number of reasons, good (such as correcting an investment mistake, or noticing a better opportunity elsewhere) and bad (purposeful churn of the portfolio without reason). We should judge the reason for turnover, not the act of turnover itself.

Hedging, Expected Return

The Fund’s returns in one period were reduced by hedging costs of approximately 2.4%. A portfolio’s expected return is equal to the % sizing weighted average expected return of the sum of its parts (holdings or allocations). Something to keep in mind as you incur the often negative carry cost of hedging, especially in today’s low rate environment.

Cliff Asness on Volatility, Risk & Loss

The debate on the relationship between volatility, risk, and permanent impairment of capital rages on. Below are some thoughts on the subject from Cliff Asness of AQR Capital Management, extracted from an article titled "My Top 10 Peeves" published earlier this year in the Financial Analysts Journal. “Volatility” Is for Misguided Geeks; Risk Is Really the Chance of a “Permanent Loss of Capital”

There are many who say that such “quant” measures as volatility are flawed and that the real definition of risk is the chance of losing money that you won’t get back (a permanent loss of capital). This comment bugs me.

Now, although it causes me grief, the people who say it are often quite smart and successful, and I respect many of them. Furthermore, they are not directly wrong. One fair way to think of risk is indeed the chance of a permanent loss of capital. But there are other fair methods too, and the volatility measures being impugned are often misunderstood, with those attacking them setting up an easy-to-knock-down “straw geek.”

The critics are usually envisioning an overvalued security (which, of course, they assume they know is overvalued with certainty) that possesses a low volatility. They think quants are naive for calling a security like this “low risk” because it’s likely to fall over time. And how can something that is expected to fall over time—and not bounce back—be low risk?

What we have here is a failure to communicate.A quant calling something “low risk” is very different from a quant saying, “You can’t lose much money owning this thing.” Even the simplest quant framework allows for not just volatility but also expected return. And volatility isn’t how much the security is likely to move; it’s how much it’s likely to move versus the forecast of expected return. In other words, after making a forecast, it’s a reflection of the amount you can be wrong on the upside or downside around that forecast. Assuming the quant and non-quant agree that the security is overvalued (if they don’t agree, then that is an issue separate from the definition of risk), the quant has likely assigned it a negative expected return. In other words, both the quant and the non-quant dislike this security. The quant just expresses his dislike with the words “negative expected return” and not the words “very risky.”

A clean example is how both types of analysts would respond to a rise in price unaccompanied by any change in fundamentals now or in the future. On the one hand, those who view risk as “the chance of permanent loss” think this stock just got riskier. Viewed in their framework, they are right. On the other hand, quants tend to say this stock’s long-term expected return just got lower (same future cash flows, higher price today) rather than its risk/volatility went up, and they too are right!

It is also edifying to go the other way: Think about a super-cheap security, with a low risk of permanent loss of capital to a long-term holder, that gets a lot cheaper after being purchased. I—and everyone else who has invested for a living for long enough—have experienced this fun event. If the fundamentals have not changed and you believe risk is just the chance of a permanent loss of capital, all that happened was your super-cheap security got superduper cheap, and if you just hold it long enough, you will be fine. Perhaps this is true. However, I do not think you are allowed to report “unchanged” to your clients in this situation. For one thing, even if you are right, someone else now has the opportunity to buy it at an even lower price than you did. In a very real sense, you lost money; you just expect to make it back, as can anyone who buys the same stock now without suffering your losses to date.

If you can hold the position, you may be correct (a chance that can approach a certainty in some instances if not ruined by those pesky “limits of arbitrage”). For example, when my firm lost money in 1999 by shorting tech stocks about a year too early (don’t worry; it turned out OK), we didn’t get to report to our clients,“We have not lost any of your money. It’s in a bank we call ‘short NASDAQ.’” Rather, we said something like, “Here are the losses, and here’s why it’s a great bet going forward.” This admission and reasoning is more in the spirit of “risk as volatility” than “risk as the chance of a permanent loss of capital,” and I argue it is more accurate. Putting it yet one more way, risk is the chance you are wrong. Saying that your risk control is to buy cheap stocks and hold them, as many who make the original criticism do, is another way of saying that your risk control is not being wrong. That’s nice work if you can get it. Trying not to be wrong is great and something we all strive for, but it’s not risk control. Risk control is limiting how bad it could be if you are wrong. In other words, it’s about how widely reality may differ from your forecast. That sounds a lot like the quants’ “volatility” to me.

Although I clearly favor the quant approach of considering expected return and risk separately, I still think this argument is mostly a case of smart people talking in different languages and not disagreeing as much as it sometimes seems.

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.”

Wisdom From James Montier

I have a confession to make: I have a huge crush on James Montier. I think the feeling might be mutual (see picture below, from a signed copy of his book Value Investing: Tools and Techniques for Intelligent Investment.) Jokes aside, below are some fantastic bits from his recent essay titled “No Silver Bullets.”

Risk, Correlation

“…private equity looks very much like public equity plus leverage minus a shed load of costs…hedge funds as an ‘asset class’ look like they are doing little more than put selling! In fact, I’d even go as far as to say if you can’t work that out, you probably shouldn’t be investing; you are a danger to yourself and to others!

The trick to understanding risk factors is to realize they are nothing more than a transformation of assets. For instance, what is the ‘equity risk?’ It is defined as long equities/short cash. The ‘value’ risk factor is defined as long cheap stocks/short expensive stocks. Similarly, the ‘momentum’ risk factor is defined as long stocks that have gone up, and short stocks that have done badly. ‘Carry’ is simply long high interest rate currencies/short low rate currencies. Hopefully you have spotted the pattern here: they are all long/short combinations.”

Proper investing requires an understanding of the exact bet(s) that you are making, and correct anticipation of the inherent risks and correlated interactivity of your holdings. This means going beyond the usual asset class categorizations, and historical correlations. For example, is a public REIT investment real estate, equity, or interest rate exposure?

For further reading on this, check out this article by Andy Redleaf of Whitebox in which he discusses the importance of isolating bets so that one does not end up owning stupid things on accident. (Ironic fact: Redleaf and Montier have butted heads in the recent past on the future direction of corporate margins.)

Leverage

“…when dealing with risk factors you are implicitly letting leverage into your investment process (i.e., the long/short nature of the risk factor). This is one of the dangers of modern portfolio theory – in the classic unconstrained mean variance optimisation, leverage is seen as costless (both in implementation and in its impact upon investors)…

…leverage is far from costless from an investor’s point of view. Leverage can never turn a bad investment into a good one, but it can turn a good investment into a bad one by transforming the temporary impairment of capital (price volatility) into the permanent impairment of capital by forcing you to sell at just the wrong time. Effectively, the most dangerous feature of leverage is that it introduces path dependency into your portfolio.

Ben Graham used to talk about two different approaches to investing: the way of pricing and the way of timing. ‘By pricing we mean the endeavour to buy stocks when they are quoted below their fair value and to sell them when they rise above such value… By timing we mean the endeavour to anticipate the action of the stock market…to sell…when the course is downward.’

Of course, when following a long-only approach with a long time horizon you have to worry only about the way of pricing. That is to say, if you buy a cheap asset and it gets cheaper, assuming you have spare capital you can always buy more, and if you don’t have more capital you can simply hold the asset. However, when you start using leverage you have to worry about the way of pricing and the way of timing. You are forced to say something about the path returns will take over time, i.e., can you survive a long/short portfolio that goes against you?”

Volatility, Leverage

“As usual, Keynes was right when he noted ‘An investor who proposes to ignore near-term market fluctuations needs greater resources for safety and must not operate on so large a scale, if at all, with borrowed money.’”

Expected Return, Intrinsic Value

“...the golden rule of investing holds: ‘no asset (or strategy) is so good that it can it be purchased irrespective of the price paid.’”

“Proponents of risk parity often say one of the benefits of their approach is to be indifferent to expected returns, as if this was something to be proud of…From our perspective, nothing could be more irresponsible for an investor to say he knows nothing about expected returns. This is akin to meeting a neurosurgeon who confesses he knows nothing about the way the brain works. Actually, I’m wrong. There is something more irresponsible than not paying attention to expected returns, and that is not paying attention to expected returns and using leverage!”

Hedging, Expected Return

“…whenever you consider insurance I’ve argued you need to ask yourself the five questions below:

1. What risk are you trying to hedge?
2. Why are you hedging?
3. How will you hedge?
• Which instruments will work?
• How much will it cost?
4. From whom will you hedge?
5. How much will you hedge?”

“This is a point I have made before with respect to insurance – it is as much a value proposition as anything else you do in investment. You want insurance when it is cheap, and you don’t want it when it is expensive.”

Trackrecord, Compounding

“…one of the myths perpetuated by our industry is that there are lots of ways to generate good long-run real returns, but we believe there is really only one: buying cheap assets.”

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 2

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 2 below, Klarman shares his thoughts on the illusory nature of liquidity, and the tricky task of knowing when to sell. Liquidity, Catalyst, When To Buy, When To Sell

Liquidity can be illusory. As Louis Lowenstein has stated, ‘In the stock market, there is liquidity for the individual but not for the whole community. The distributable profits of a company are the only rewards for the community.’ In other words, while any one investor can achieve liquidity by selling to another investor, all investors taken together can only be made liquid by generally unpredictable external events such as takeover bids and corporate-share repurchases. Except for such extraordinary transactions, there must be a buyer for every seller of a security."

Liquidity is possible not only through sale of securities, but also through other events & catalysts that result in cash flowing into the portfolio. 

“In times of general market stability the liquidity of a security or class of securities can appear high. In truth liquidity is closely correlated with investment fashion. During a market panic the liquidity that seemed miles wide in the course of an upswing may turn out only to have been inches deep. Some securities that traded in high volume when they were in favor may hardly trade at all when they go out of vogue.”

“For many securities the depth of the market as well as the quoted price is an important consideration. You cannot sell, after all, in the absence of a willing buyer; the likely presence of a buyer must therefore be a factor in the decision to sell. As the president of a small firm specializing in trading illiquid over-the-counter (pink-sheet) stocks once told me: ‘You have to feed the birdies when they are hungry.’”

Historical liquidity does not equal future liquidity. Miscalculation on this front has contributed to a phenomenon eloquently described as “up the stairs, out the window” syndrome.

When To Sell, Expected Return, Risk, Opportunity Cost

“Many investors are able to spot a bargain but have a harder time knowing when to sell. One reason is the difficulty of knowing precisely what an investment is worth. An investor buys with a range of value in mind at a price that provides a considerable margin of safety. As the market price appreciates, however, that safety margin decreases; the potential return diminishes and the downside risk increases. Not knowing the exact value of the investment, it is understandable that an investor cannot be confident in the sell decision as he or she was in the purchase decision.

To deal with the difficulty of knowing when to sell, some investors create results for selling…none of these rules make good sense. Indeed, there is only one valid rule for selling: all investments are for sale at the right price…Decisions to sell, like to buy, must be based upon underlying business value. Exactly when to sell – or buy – depends on the alternative opportunities that are available…It would be foolish to hold out for an extra fraction of a point of gain in a stock selling just below underlying value when the market offers many bargains.”

Awhile ago, we featured an interview with Steve Romick of FPA discussing the sizing & dilemma of whether to sell as price moves closer, though not quite yet, to intrinsic value. Here, Klarman's comment advises investors to also take into consideration "alternative opportunities that are available" during this decision making process.

When To Buy

“In my view, investors should usually refrain from purchasing a ‘full position’ (the maximum dollar commitment they intend to make) in a given security all at once…Buying a partial position leaves reserves that permit investors to ‘average down’ lowering their average cost per share, if prices decline.

Evaluating your own willingness to average down can help you distinguish prospective investments from speculations. If the security you are considering is truly a good investment, not a speculation, you would certainly want to own more at lower prices.”

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."

Asymmetry Revisited

Return asymmetry is a topic that emerges over and over again on PM Jar. It’s a topic that spans across investments strategies and philosophies (see the end of this article for links to previous PM Jar articles on return asymmetry). This is no coincidence – creating (positive) return asymmetry over time is the hallmark of great investors. So why is it so important to achieve positive return asymmetry (through decreasing the number of left tail / negative return occurrences)? Because positive return asymmetry saves investors from wasting valuable time and effort digging out of the negative return hole (compounding math is not symmetric: losing 50% in one period requires gaining 100% in the next period just to breakeven). This holds true for all investors, regardless of investment strategy and philosophy, hence why the theme of return asymmetry comes up so often.

Our last article on Howard Marks discussing the ability of a fund manager to outperform and add-value by reducing risk reminded me of article that a kind Reader sent me earlier this summer (Comgest Commentary 2013 July) in which the author describes with refreshing clarity the importance of creating positive return asymmetry and the interplay between compounding, capital preservation, and risk management. Compounding, Capital Preservation, Trackrecord

“The Asymmetry of Returns Dictates the Compounding of Returns:

Berkshire Hathaway CEO and legendary investor Warren Buffett is often quoted as saying, “Rule No.1: Never lose money. Rule No. 2: Never forget rule No. 1.” But why are these the most important two (well, one) rules of investing? The answer lies in the inherent asymmetry of returns, which is the basis for how returns compound over time.

If you start with $100 and subsequently gain 10% and then lose 10%, it may be surprising that you don’t end up back with the same $100 you had at the beginning. The reason is that your 10% loss hurt more, because it came off the larger asset base you had after your 10% gain. In sequence: $100 → gain 10% ($10) → $110 → lose 10% ($11) → $99. You can reverse the order of the gain and loss and the end result is still the same: $100 → $90 → $99, where your percentage loss is still based on a higher amount of capital than is your percentage gain. The end result is a net loss of 1%, hence the asymmetry – gains and losses of equal percentages have different impacts. As your returns swings get larger, this effect becomes more pronounced. For instance, starting with $100 and then gaining/losing 20% leaves you with a net loss of 4%, while gaining/losing 50% leaves you with a net loss of 25%. At the extreme, gaining/losing 100% leaves you with a net loss of 100% – all your capital, resulting on complete ruin. It doesn’t matter what any of the other payoffs are for someone who at any one point loses his or her entire bankroll.

Another way to look at this is to see what kind of return is necessary to get back to even after a loss. If you lose 10%, you need an 11% gain to get back to even. If you lose 20%, you need a 25% gain to close the gap. Losing 50% requires a doubling of your money, while losing 90% means you need a 900% return (!) to compensate. While 100% losses are rare in equity portfolios and thus true ruin is unlikely, this exercise shows how large losses cripple the long-term returns of a portfolio.”

“...the goal is to avoid an 'extinction' event, which I’ve put in quotes because extinction for an investment portfolio doesn’t only mean complete disappearance. It can also be seen as irreparable damage to a long-term track record.”

Risk

“Risk Management and Higher Math Are Not Natural Partners:

…The prevailing view of risk management in today’s investment world seems to be that it must be done with a lot of math and only a set of numbers, preferably from a complicated model, can describe an approach to risk. That’s just not how we see it. Instead, we think understanding the companies’ profitability characteristics is a far more effective way to understand the risk embedded in a portfolio. We side with James Montier, who wrote, “The obsession with the quantification of risk (beta, standard deviation, VaR) has replaced a more fundamental, intuitive, and important approach to the subject. Risk clearly isn’t a number. It is a multifaceted concept, and it is foolhardy to try to reduce it to a single figure.” Even the revered father of modern security analysis, Benjamin Graham, tips his cap to a more fundamental and less market-price-driven approach to risk: “Real investment risk is measured… by the danger of a loss of quality and earnings power through economic changes or deterioration in management.” It’s important to realize that our view of risk is at the fundamental security level, while standard industry risk models start from price volatility and covariance matrices, which are market-level inputs. In other words, we focus on what’s happening in the business, not what’s going on in the market, to understand risk. We think that our approach to risk management, that of decreasing the left tail of the distribution of potential outcomes by buying quality stocks is a more time-tested approach that runs a far lower risk of model specification error.”

In case you'd like some related reading, here is what Howard Marks, Stanley Druckenmiller, Warren Buffett, and others have said about return asymmetry.

Howard Marks' Book: Chapter 15

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 15 “The Most Important Thing Is…Having a Sense for Where We Stand.” Cash, Risk, Opportunity Cost

“The period from 2004 through the middle of 2007 presented investors with one of the greatest opportunities to outperform by reducing their risk, if only they were perceptive enough to recognize what was going on and confident enough to act…Contrarian investors who had cut their risk and otherwise prepared during the lead-up to the crisis lost less in the 2008 meltdown and were best positioned to take advantage of the vast bargains it created.”

The quote above highlights a concept not given enough attention within the investment management industry – a fund manager’s ability to generate outperformance (versus a benchmark or on an absolute basis) derives not only from his/her ability to capture upside return, but also by avoiding downside loss!

Marks’ comment that some investors were “best positioned to take advantage” of newly available bargains reminds us of an interesting theoretical discussion on the value of cash, which it is based on not only what you can earn or purchase with it today, but also on what you can potentially purchase with it in the future. Jim Leitner, a former Yale Endowment Committee Member summarizes this concept best: “…we tend to ignore the inherent opportunity costs associated with a lack of cash…cash affords you flexibility…allocate that cash when attractive opportunities arise…When other assets have negative return forecast…there is no reason to not hold a low return cash portfolio…The correct way to measure the return on cash is more dynamic: cash is bound on the lower side by its actual return, whereas, the upper side possesses an additional element of positive return received from having the ability to take advantage of unique opportunities…Holding cash when markets are cheap is expensive, and holding cash when markets are expensive is cheap.”

Expected Return

“The seven scariest words in the world for the thoughtful investor – too much money chasing too few deals…You can tell when too much money is competing to be deployed…

…It helps to think of money as a commodity…Everyone’s money is pretty much the same. Yet institutions seeking to add to loan volume, and private equity funds and hedge funds seeking to increase their fees, all want to move more of it. So if you want to place more money – that is, get people to go to you instead of your competitors for their financing – you have to make your money cheaper.

One way to lower the price for your money is by reducing the interest rate you charge on loans. A slightly more subtle way is to agree to a higher price for the thing you’re buying, such as by paying a higher price/earnings ratio for a common stock or a higher total transaction price when you’re buying a company. Any way you slice it, you’re settling for a lower prospective return.”

The future expected return of any asset is a direct function of the price that you pay combined with the economic return potential of that asset.

Psychology, Risk, When To Buy, When To Sell

“…even if we can’t predict the timing and extent of cyclical fluctuations, it’s essential that we strive to ascertain where we stand in cyclical terms and act accordingly.”

“If we are alert and perceptive, we can gauge the behavior of those around us and from that judge what we should do. The essential ingredient here is inference, one of my favorite words. Everyone sees what happens each day, as reported in the media, But how many people make an effort to understand what those everyday events say about the psyches of market participants, the investment climate, and thus what we should do in response? Simply put, we must strive to understand the implications of what’s going on around us. When others are recklessly confident and buying aggressively, we should be highly cautious; when others are frightened into inaction or panic selling, we should become aggressive.”

“There are few fields in which decisions as to strategies and tactics aren’t influenced by what we see in the environment. Our pressure on the gas pedal varies depending on whether the road is empty or crowded. The golfer’s choice of club depends on the wind. Our decisions regarding outerwear certainly varies with the weather. Shouldn’t our investment actions be equally affected by the investing climate?”

Baupost Letters: 1999

Continuation in our series on portfolio management and Seth Klarman, with ideas extracted from old Baupost Group letters. Our Readers know that we generally provide excerpts along with commentary for each topic. However, at the request of Baupost, we will not be providing any excerpts, only our interpretive summaries, for this series.

Sizing, Catalyst, Expected Return, Hurdle Rate, Cash, Hedging, Correlation, Diversification

In the 1999 letter, Klarman breaks down the portfolio, which consists of the following components:

1. Cash (~42% of NAV) – dry powder, available to take advantage of bargains if/when available
2. Public & Private Investments (~25% of NAV) – investments with strong catalysts for partial or complete realization of underlying value (bankruptcies, restructurings, liquidations, breakups, asset sales, etc.), purchased with expected return of 15-20%+, likelihood of success dependent upon outcome of each situation and less on the general stock market movement. This category is generally uncorrelated with markets.
3. Deeply Undervalued Securities – investments with no strong catalyst for value realization, purchased at discounts of 30-50% or more below estimated asset value. “No strong catalyst” doesn’t mean “no catalyst.” Many of the investments in this category had ongoing share repurchase programs and/or insider buying, but these only offered modest protection from market volatility. Therefore this category is generally correlated with markets.
4. Hedges (~1% NAV)

Often, investments are moved between category 2 and 3, as catalyst(s) emerge or disappear.

This portfolio construction approach is similar to Buffett’s approach during the Partnership days (see our 1961 Part 3 article for portfolio construction parallels). Perhaps Klarman drew inspiration from the classic Buffett letters. Or perhaps Klarman arrived at this approach independently because the “bucket” method to portfolio construction is quite logical, allowing the portfolio manager to breakdown the attributes (volatility, correlation, catalysts, underlying risks, etc.) and return contribution of each bucket to the overall portfolio.

Klarman also writes that few positions in the portfolio exceed 5% of NAV in the “recent” years around 1999. This may imply that the portfolio is relatively diversified, but does lower sizing as % of NAV truly equate to diversification? (Regular readers know from previous articles that correlation significantly impacts the level of portfolio diversification vs. concentration of a portfolio.) One could make the case that the portfolio buckets outlined above are another form of sizing – a slight twist on the usual sizing of individual ideas and securities – because the investments in each bucket may contain correlated underlying characteristics. 

Duration, Catalyst

Klarman reminds his investors that stocks are perpetuities, and have no maturity dates. However, by investing in stocks with catalysts, he creates some degree of duration in a portfolio that would otherwise have infinite duration. In other words, catalysts change the duration of equity portfolios.

Momentum

Vicious Cycle = protracted underperformance causes disappointed holder to sell, which in turn produces illiquidity and price declines, prompting greater underperformance triggering a  new wave of selling. This was true for small-cap fund managers and their holdings during 1999 as small-cap underperformed, experienced outflows, which triggered more selling and consequent underperformance. The virtuous cycle is the exact opposite of this phenomenon, where capital flows into strongly performing names & sectors.

Klarman’s commentary indirectly hints at the hypothesis that momentum is a by-product of investors’ psychological tendency to chase performance.

Risk, Psychology

Klarman writes that financial markets have been so good for so long that fear of market risk has completely evaporated, and the risk tolerance of average investors has greatly increased. People who used to invest in CDs now hold a portfolio of growth stocks. The explanation of this phenomenon lies in human nature’s inability to comprehend that we may not know everything, and an unwillingness to believe that everything can change on a dime.

This dovetails nicely with Howard Mark’s notion of the ‘perversity of risk’:

“The ultimate irony lies in the fact that the reward for taking incremental risk shrinks as more people move to take it. Thus, the market is not a static arena in which investors operate. It is responsive, shaped by investors’ own behavior. Their increasing confidence creates more that they should worry about, just as their rising fear and risk aversion combine to widen risk premiums at the same time as they reduce risk. I call this the ‘perversity of risk.’”

When To Buy, Psychology

Klarman writes that one should never be “blindly contrarian” and simply buy whatever is out of favor believing it will be restored because often investments are disfavored for good reason. It is also important to gauge the psychology of other investors – e.g., how far along is the current trend, what are the forces driving it, how much further does it have to go? Being early is synonymous to being wrong. Contrarian investors should develop an understanding of the psychology of sellers. Sourcing

When sourcing ideas, Baupost employs no rigid formulas because Klarman believes that flexibility improves one’s prospectus for returns with limited risk.

The Managing vs. Marketing of Risk

There’s something in the Santa Barbara water (or wine) that produces some extremely thoughtful investors/writers. Some of you already know that I’m a fan of Eric Peters of Weekend Notes (who resides in Santa Barbara). A friend recently told me about Stephen Duneier of Bija Capital Management (another Santa Barbara resident) who also has been writing thought provoking letters. Below are excerpts from a piece written a few weeks ago on risk management, titled “The Managing vs. Marketing of Risk.” For those of you who appreciate differentiated opinions, it’s a worthwhile read. Risk

“ 'You can take risk. Just don't lose money.' - A Former Boss

Risk management seems like a simple endeavor. It’s not. It requires a deep understanding of what risk is and how it can be managed. Some think that simply being strong is the answer. It’s not. Many think of risk as something you deal with after the fact, and it shows in their pitch. “I will force positions to be shut down.” “I will step in and close positions myself.” “We will cut risk...” All of these statements reflect a reactive risk management process. While they sound tough and disciplined, they are really just impulsive behaviors attempting to clean up impulsive behaviors, after the damage has already been inflicted. Fact is, the biggest hedge fund disasters don’t occur when funds are doing poorly. They come about when they are doing well, and risk management has been sidelined. That’s why every loss and every gain attracts my interest in exactly the same way, for the most effective risk management is both proactive and consistent execution.”

“The speed bump is a generally accepted risk management tool. Essentially it serves as a line in the sand which triggers a specific reaction. As an example, if a portfolio manager is down 5% from the high water mark (HWM; peak profit), then her risk is halved. If it happens again, risk is halved again, and so on. It's one of those things that sound good in a marketing presentation, allowing a fund manager to masquerade as a disciplined risk manager. The problem is that its mere existence creates an impediment to thinking deeper about and implementing more effective, proactive risk management procedures. Worse yet, speed bumps ultimately serve two distinct purposes. They reduce the returns of a good investment manager and they extend the life of a poor one. The better the manager, the more dramatic the negative impact, and vice-versa…in every case where the PM is a positive performer, your returns will be better without a speed bump. What about the poor performer? Simply stated, you should fire him.”

PM Jar Exclusive Interview With Howard Marks - Part 4 of 5

Below is Part 4 of PM Jar’s interview with Howard Marks, the co-founder and chairman of Oaktree Capital Management, on portfolio management. Part 4: The Art of Transforming Symmetry into Asymmetry

“If tactical decisions like concentration, diversification, and leverage are symmetrical two-way swords, then where does asymmetry come from? Asymmetry comes from alpha, from superior personal skill.”

Marks: Everything in investing is a two-way sword – a symmetrical two-way sword. If you turn cautious and raise cash, it will help you if you are right, and hurt you if you are wrong. If tactical decisions like concentration, diversification, and leverage are symmetrical two-way swords, then where does asymmetry come from? Asymmetry comes from alpha, from superior personal skill.

Superior investors add value in a number of ways, such as security selection, knowing when to drop down in quality and when to raise quality, when to concentrate and when to diversify, when to lever and when to delever, etc. Most of those things come under the big heading of knowing when to be aggressive and when to be defensive. The single biggest question is when to be aggressive and when to be defensive.

I believe very strongly that investors have to balance two risks: the risk of losing money and the risk of missing opportunity. The superior investor knows when to emphasize the first and when to emphasize the second – when to be defensive (i.e., to worry primarily about the risk of losing money) and when to be aggressive (i.e., to worry primarily about the risk of missing opportunity). In the first half of 2007, you should have worried about losing money (there was not much opportunity to miss). And in the last half of 2008, you should have worried about missing opportunity (there wasn’t much chance of losing money). Knowing the difference is probably the most important of all the important things.

PM Jar: How do you think about the opportunity cost when balancing these two risks? Is it historical or forward looking?

Marks: If you bought A, your opportunity cost is what you missed by not holding B. That’s historical. Similarly, when you look forward, you can take an infinite number of different actions in putting together your portfolio.Opportunity cost is what you could lose by doing what you’re doing, as opposed to other things that you could have done.

Opportunity cost is a sophisticated sounding way to address the risk of doing something versus the risk of not doing it. This is how we decide whether and how to invest: If I buy it, could I lose money? If I don’t buy it, could I miss out on something? If I buy a little, should I have bought a lot? If I bought a lot, should I have bought a little?

Investing is an art form in the sense that it can’t be mechanized. There is no formula or rule that works – it’s all feel. You get the inputs, analyze them, turn the crank, get numbers out – but they are only guesswork. Anything about the future is only a guess. The best investing is done by people who make the best subjective judgments.

Anyone who thinks they are going to make all decisions correctly is crazy. But if you make mistakes, you have to learn from them. Otherwise you’re making another huge mistake if you ignore the learning opportunity. One of my favorite sayings is, “Experience is what you got when you didn’t get what you wanted.”

Continue Reading — Part 5 of 5: Creating Your Own Art

Bill Lipschutz: Dealing With Mistakes

The following excerpts are derived from Jack Schwager’s interview with Bill Lipschutz in The New Market Wizards. Lipschutz helped build and ran Salomon’s currency desk for many years – here is a 2006 EuroMoney Article with additional background on Bill Lipschutz. There are number of worthwhile portfolio management tidbits here, mainly the relationship between making mistakes, portfolio sizing & exposure, and controlling one’s psychological reactions. Mistake, Liquidity, Psychology, Process Over Outcome

“Missing an opportunity is as bad as being on the wrong side of a trade…”

“…the one time since I first started trading that I was really scared…our position size at the time was larger than normal…the dollar started moving up in New York, and there was no liquidity. Very quickly it was up 1 percent, and I knew that I was in trouble [1% of $3 billion = $30 million loss]…It transpired in just eight minutes. All I wanted to do was to make it through to the Tokyo opening at 7pm for the liquidity…By the time Tokyo opened, the dollar was moving down, so I held off covering half the position as I had previously planned to do. The dollar kept collapsing, and I covered the position in Europe…The reason that I didn’t get out on the Tokyo opening was that it was the wrong trading decision...

…That was the first time it hit home that, in regards to trading, I was really very different from most people around me. Although I was frightened at the time, it wasn’t a fear of losing my job or concern about what other people would think of me. It was a fear that I had pushed the envelope too far – to a risk level that was unacceptable. There was never a question in my mind about what steps needed to be taken or how I should go about it. The decision process was not something that was cloudy or murky in my vision. My fear was related to my judgment being so incorrect – not in terms of market direction (you can get that wrong all the time), but in terms of drastically misjudging the liquidity. I had let myself get into a situation in which I had no control. That had never happened before.”

“Q: Let’s say that the dollar started to go up – that is, in favor of the direction of your trade – but the fundamentals that provided your original premise for the trade has changed. Do you still hold the position because the market is moving in your favor, or do you get out because your fundamental analysis has changed?

A: I would definitely get out. If my perception that the fundamentals have changed is not the market’s perception, then there’s something going on that I don’t understand. You don’t want to hold a position when you don’t understand what’s going on. That doesn’t make any sense.”

Liquidity is your friend when it comes to dealing with mistakes.

Mistakes, Psychology, Sizing, When To Buy, When To Sell, Exposure, Expected Return

“When you’re in a losing streak, your ability to properly assimilate and analyze information starts to become distorted because of the impairment of the confidence factor, which is a by-product of a losing streak. You have to work very hard to restore that confidence, and cutting back trading size helps achieve that goal.”

“Q: For argument’s sake, let’s say that the fundamentals ostensibly don’t change but the dollar starts going down. How would you decide that you’re wrong? What would prevent you from taking an open-ended loss?

A: …if the price action fails to confirm my expectations will I be hugely long? No, I’m going to be flat and buying a little bit on the dips. You have to trade at a size such that if you’re not exactly right in your timing, you won’t be blown out of your position. My approach is to build to a larger size as the market is going my way. I don’t put on a trade by saying, “My God, this is the level; the market is taking off right from here.” I am definitely a scale-in type of trader.

Q: Do you believe your scaling type of approach in entering and exiting positions is an essential element in your overall trading success?

A: I think it has enabled me to stay with long-term winners much longer than I’ve seen most traders stay with their positions. I don’t have a problem letting my profits run, which many traders do. You have to be able to let your profits run. I don’t think you can consistently be a winning trader if you’re banking on being right more than 50% of the time. You have to figure out how to make money being right only 20 to 30 percent of the time.”

Very interesting way to think about overall expected return of a portfolio – how to make profits if you are right only 20-30% of the time. This highlights the concept that in investing, it doesn’t matter how often you are right or wrong, what ultimately matters is how much you make when you are right and how much you lose when you are wrong.

Volatility, Exposure, Correlation

“…playing out scenarios is something that I do all the time. That is a process a fundamental trader goes through constantly. What if this happens? What if this doesn’t happen? How will the market respond? What level will the market move to…

…Generally speaking, I don’t think good traders make gut or snap decisions – certainly not traders who last very long. For myself, any trade idea must be well thought out and grounded in reason before I take the position. There are a host of reasons that preclude a trader from making a trade on a gut decision. For example, before I put on a trade, I always ask myself, ‘If this trade does wrong, how do I get out?’ That type of question becomes much more germane when you’re trading large position sizes. Another important consideration is the evaluation of the best way to express a trade idea. Since I usually tend not to put on a straight long or short position, I have to give a lot of thought as to what particular option combination will provide the most attractive return/risk profile, given my market expectations. All of these considerations, by definition, preclude gut decisions.”

Is not “playing out scenarios” within one’s mind a form of attempting to anticipate possible scenarios of expected volatility?

Trade structuring is an under-discussed topic. Many people buy or short things without understanding/considering the true exposure – standalone and/or when interacting with existing portfolio positions. In the words of Andy Redleaf of Whitebox, “The really bad place to be is where all too many investors find themselves much of the time, owning the wrong things by accident. They do want to own something in particular; often they want to own something quite sensible. They end up owning something else instead.”

Sizing, Psychology

“Q: Beside intelligence and extreme commitment, are there any other qualities that you believe are important to excel as a trader?”

A: Courage. It’s not enough to simply have the insight to see something apart from the rest of the crowd, you also need to have the courage to act on it and to stay with it. It’s very difficult to be different from the rest of the crowd the majority of the time, which by definition is what you’re doing if you’re a successful trader.”

Also true for fundamental investors.

Risk, Diversification, Exposure

“Q: How did the sudden demise of your personal account change you as a trader?

A: I probably became more risk-control oriented. I was never particularly risk averse…There are a lot of elements to risk control: Always know exactly where you stand. Don’t concentrate too much of your money on one big trade or group of highly correlated trades. Always understand the risk/reward of the trade as it now stands, not as it existed when you put the position on. Some people say, ‘I was only playing with the market’s money.’ That’s the most ridiculous thing I ever heard.”

Team Management

“…John [Gutfreund of Salomon Brothers] could smell death at a hundred paces. He didn’t need to know what your position was to know…how it was going. He could tell the state of your equity by the amount of anxiety he saw in your face.”

Time Management

“By the way, when I talk about working hard, I meant commitment and focus; it has nothing to do with how many hours you spend in the office.”