Topic: Building a professional investment portfolio
Details: A specific question regarding adjusting the asset class weights in a diversified portfolio when an asset class has fallen in value
Summary: Any negative amount counts as a negative year and thus triggers an increase in weights
Nuance: It’s still up to you how much, if at all to adjust the weights, since the system hasn’t been scientifically optimized
This is my e-mail answer to a question from a reader in Hong Kong regarding when to adjust the asset class weights in a Quattro Stagione portfolio (that I talk about in this post among others that you can find here under Investments):
Regarding the VQS system, The Variable Quattro Stagione
I actually literally mean any negative amount for a market counts as time for adjusting the Quattro Stagione weights.
However, I haven’t optimized the system statistically over time, markets, asset classes etc. for different thresholds. I’ll leave that to you for your specific QS toppings. I do think “negative” is something most investors try to avoid, and that window dressing makes sure years typically end positive if at all possible. That’s why “negative” is a kind of magical threshold.
That said, it’s not inconceivable that +2%, -2%, -5% or some other amount would work even better as the cut-off point. Similarly, how much to adjust the weights hasn’t been optimized either — the Variable Quattro Stagione is more of a conceptual framework, and the best parameters will vary between regions, asset classes, time periods and so on anyway.
The reason the VQS should work better than fixed weights (i.e., less drawdowns or volatility for the same or better total return) is that market forces, crowd psychology etc. historically typically has produced a pattern of a handful of positive years followed by a couple of negative years. Actually, even without varying the weights you’ll get some of the benefits from the “up much, down less” pattern, since you’ll re-weight the losers upward to their default weight. Increasing the weights even more simply emphasizes that effect.
The pattern could be something like this in terms of years for stocks in one country: +6, -1, +4, -1, +7, -2, +5, -1, +9. Check a few asset classes yourself, e.g., gold, gov bonds, corporate inv grade bonds, junk bonds, US stocks, Chinese stocks, UK stocks…
That should give you a hint of the value of doubling up on an asset class after a few negative years, and reducing weights (possibly significantly) for classes that have just gone through more than 5 or 7 positive years in a row.
As an aside, right now, after 8 consecutive positive years (going on 9) for the western stock markets, I would keep the equity weight at a minimum, in particular if it’s a country index.
However, the model actually states that you keep the default weight of 25%, and even increase it to 40% if this year ends below zero. My actual publicly listed net equity weight is just a couple per cent; 1-2% approximately (including my gold miners ETF exposure “GDX”). The reason I can’t be more precise is that my gf Anna is managing a small part of my wealth and I have no clue what she’s doing with it from day to day.
If you’re new here, do check out my previous post where I listed all my investments and why I own them. Also don’t forget to subscribe and read my book about investing.
I have friends and acquaintances opening new funds all the time, it seems. This post is an open letter to them. This is my advice to you, P/S, who are thinking about going live managing money right now.
To be perfectly clear though, everybody who recently started investing or is thinking about it should read this article carefully. Not only because of the negative start to the year for most, but because the bigger picture is so much…bigger than a January loss.
*about managing money
Well, ehm, first we bought GoPro…
If you haven’t managed money before, you really know nothing about the craft (luckily, both of you actually have)
That’s okay, it’s not that hard, really, it’s “just” multifaceted and complex (and actually inherently non-understandable… -or was it just me?). On the other hand, most things worth pursuing are.
A watch is complicated,
the three body problem is complex
Quite understandably though, I constantly have to field questions about investing. The main problem is that I typically don’t adhere to the same underlying basic strategy, thus rendering most detailed tactical inquiries moot.
Hence, you should refer back to the linked material, whenever you feel anything is unclear.
This particular post outlines a few general points you need to consider before commencing managing your or clients’ money. I don’t provide any answers per se, only suggestions and a smorgasbord of choices.
Beware. After all, this is treacherous ground. Managing money is both difficult, complex and dangerous, albeit not very complicated (i.e. not too many moving parts, but as Newton knew, three is plenty).
That said, it isn’t for everybody, maybe not for you. How would you feel, e.g., about losing 50%?
It’s pretty straight forward. Anybody could do it.
Just open an account and start buying things (stocks, bonds, commodities, derivatives, whatever you fancy). Once your cash runs out, you simply sell something whenever you want to buy something else, or borrow and use leverage.
(probably poorly though)
However, if you want some (professional) structure to it, listed below are the basic building blocks. Most of all they help you avoid common mistakes, as well as keep losses to a minimum (given your chosen strategy).
Avoiding mistakes is much more important than hitting homeruns when it comes to serious long-term professional investing
Decide on a strategy
This is probably the most common mistake of all. Investing is like air to us or water to fish. Most take it for granted and never take a closer look at what it really entails. Thus…,
Decide explicitly what your overall investment strategy will be:
International or domestic (hint: international)
Which asset classes (stocks, bonds, commodities, currencies, derivatives, precious metals, etc. – yup, investing is not about stocks only)
Long only (remember I thanked the “long-only herd” when receiving the 2008 Hedge Fund Of The Year award)
which index (Whaddya mean, which index; are there other than S&P500? It’s never easy, is it?)
Market neutral (Good luck Chuck! Sounds good, but alpha is often elusive and you end up doing an involuntary epic split between two different trucks)
Market timer (if there ever were a losing strategy…)
The fund I managed, Futuris (Brummer) – the European Hedge Fund Of The Decade (Nota Bene), invested in stocks only and we were to some extent market timers, in as much as we deliberately controlled the overall net exposure of the fund. We invested internationally, albeit with a focus on northern Europe. We were completely index independent and non-biased in every way.
-How will you decide what individual positions to take?
Btw, do you think of fair multiples in terms of what others (“the market”) is likely to pay, or in terms of true intrinsic value from your own point of view – i.e., a kind of yield calculation shortcut?
DCF analysis (“true” valuation, but rather impractical and deceptive sometimes. Numbers in a spreadsheet are no truer than lines in a chart)
Operations momentum (are fundamentals accelerating or surprising?)
Should you heed broker recommendations?
How do you plan to use analysts?
For information only
Implement their alpha recommendations
Technical analysis (TA)
Manual (intuitive, ocular)
Computer driven, data mining
Simple regressions (work until they don’t)
Complex (e.g., Lorenz’ strange attractor analysis for style gliding and trend change detection/prediction)
General, commonly acknowledged, patterns (see “Reminiscences of a stock operator” for some background on the psychological underpinnings)
Stock specific patterns with statistical backtracking
Combination of FA and TA
Cross asset signals
What do commodities, bonds, precious metals, high-yield fixed income instruments etc. say about risk tolerance and growth, and consequently about the potential for stocks?
Investments, productivity, inventories, sales, employment, policy rates and economic growth, and their effects on profits and valuations
Futuris was mainly based on fundamental, bottom-up, analysis, with a focus on unrecognized operations momentum and DCF analysis. Key ratios did play an important part as well.
FA often is based on triangulation of several valuation methods, which is exactly what we did. We did apply some experience-based intuitive hedging as well; whether that should be considered FA or TA isn’t clear. On top of it all, we kept track of coross-asset signals as well as the macroeconomic trajectory and its potential impact on specific industries and stock markets.
Considering we won the “European Hedge Fund Of The Decade” award from HFR for the period 2000-2009, I’d say Futuris’ overall approach worked, even if it could have been refined and optimized further. Sometimes hubris got the better of us.
Futuris’ Awards, ominously quiet 2003-2007
What do you do when things go south?
You will lose money.
Yeah, yeah, I know…
No, you will lose money, more than you anticipate, and you need a plan for that (Hedgehogging by Barton Biggs, or my own eBook both tell you a lot about the particularities of finding oneself deep in the red):
Stop loss levels and procedures
How much and for how long are you (and your clients) ready to lose for something you believe in
Length of pause between a stop loss and restarting
Procedure for restarting
All at once, or gradually
Are the same (losing) positions acceptable alternatives? Under which circumstances?
a somewhat unorthodox principle of investing, where “enough is enough” and you cut your cash cows when they’ve run far enough, or rather too far. That way you avoid sudden mean reversions.
Futuris had an informal, soft stop loss level of 5% losses at the portfolio level. Individual positions, however, were allowed much more leeway. There were instances of doubling up at a 50% loss, and at least one (albeit marginal) instance of going 10-fold on a -90% loser. We had no specified pause length before restarting, but we almost always eased back into the market gradually over a few weeks. I personally did apply a kind of stop-profit methodology, trimming winners on surges.
Alright, so you have your strategy and some tactics in place. What about where the rubber meets the road? How do you perform the actual deals?
How frequent trading?
minutes and seconds
Number of instruments
Some advocate a maximum of 5-10 positions – to make every investment matter and count, as well as increase the depth of knowledge
Some take hundreds of small market neutral “spreads”, reducing single stock and market risk to a minimum
Perhaps, you plan to just buy and sell here and there and see how many you’ll get to over time?
Overall exposure range (+/-10%, 50-80%, 97-100%, 70-130%, +/- 100%)
Do you plan to have any cash at all?
If so, where will you keep it?
Level of aggressivity
Marginal opportunistic changes within a strategic position
Catching both up swings and down swings, no matter the trend direction (aggressive)
Commission and research expenses
How much are you prepared to pay per trade, or per year
Are you buying execution services (placing power) or will you rely mainly on DMA (Direct Market Access, self-help)?
Will you pay for research? How much? What is an acceptable ROI on that investment? How do you plan to measure the effectiveness of third party research?
For a fund of 1-1.5bn USD, Futuris was unusually agile. Sometimes we bought or sold the entire portfolio (100% of assets under management, AUM) in a single day. Most days, however, we typically executed less than 5 minor trades (less than 1% of AUM each). The extreme measures outlined above were reserved for stop-losses or profit taking in extreme market situations, such as 9/11 (2001), Hedge Fund Hell (August 2007), the Kerviel debacle (2008) and the Fukushima disaster (2011 tsunami and nuclear meltdown).
Futuris usually held around 40 different instruments (38 stocks, one long or short future and perhaps an index sell option), albeit more (60) the last few years.
Our overall exposure range was approximately -50% to +100% of AUM. We managed our liquidity conservatively (cash at bank or in short dated treasury notes). We were minimally aggressive regarding trading – once we had decided an instrument was going up or down we held the basic position steady with only minor trading on the margin (10-25% of the position), rather than actively calling temporary counter trends. Going both ways we left to more free-thinking spirits.
So, how should you manage your money?
I can’t tell you that, and I can’t recommend you follow my example either. I only want to make sure you understand the universe you’re about to enter.
Anyway, I think most investors should apply some sort of passive Buy and Hold stock strategy or a semi-passive Quattro Staggione strategy (stocks, gov bonds, gold, corp bonds). Going deeper is just a waste of time and a source of frustration for most.
I, however, am not most people (so I’ve heard).
I am currently heavily net short the stock market. Yes, that’s right; I haven’t just reduced my quattro stock slice from 25% to 20% or 15% or 0% for that matter. I’m way down at -100%!
It’s served me well recently, and even if I’m still basically 100% short, it’s less short than just a week ago. Hence, I’m actually ready for a temporary market bounce right now.
I know it sounds strange to some, but I have decided on a negative stock market exposure for the mid term, and will thus only trade around that position marginally – for fun and to stay tuned to the market.
I will not go tactically long on a gut feeling and risk being caught in an air pocket. It’s a bear market and they famously make everybody look stupid before they’re over.
Apart from (negative) stocks, I own quite a bit of gold (GLD) and gold mines (GDX), and I keep buying oil (Brent, and the oil exploration stocks DNO and Shamaran, which are both highly speculative punts on the KRG actually paying for the oil. That in turn probably means the oil price must rise above a certain threshold within a certain time lest they all go bankrupt, including the Kurdistan Regional Government).
This is not responsible. Do not follow my lead.
NB that I don’t really manage my money in the true sense of the word. I’m betting on a downturn, after which I will start managing again. I’m doing it in part for fun, in part because I think I’m right.
Usually, and for most, it’s not a good idea to try to time the market. It only brings unnecessary frustration and consumes a lot of time.
Once it’s time to get professional again, I need to buy a much more diverse set of international companies. Depending on how far down the market goes, I just might go 100% long stocks, or more, for some time, while possibly using leverage in order to hold some gold as well. My oil investments are not for the long run, but how can you resist the world’s most important commodity when it’s down by 80%?
Yes, I know all about the Saudis needing the money, Iran coming online again, the promise of Shale, not to mention the expansion of solar power, carbon taxes etc. Please note that most oil people knew all about that already 2 years ago, with oil 300% higher than today (i.e. at 4x today’s price). This is not the place to discuss peak oil or its inversion, today the topic is overarching principles for managing a fund.
OK… so what’s in it for me, you think. I don’t get it, should I invest or not? What stocks should I buy? Or should I sell the ones I own?
No, no, no!
What you should do is just think through the following before starting to manage a fund or your own money:
Should you at all manage your own money? Check out the pitfalls here. Is it worth it? Read the pitfall article and then decide whether active investing is something for you. It really isn’t for everybody.
Is there some other alternative you could pursue, that would be more predictable, worthwhile (and fulfilling)
What asset classes and regions?
Doing everything and everybody is seldom a good strategy unless you have plenty of experience or a large staff ;)
Jumping haphazardly from one thing to another just means more time spent learning and losing. You could trade just one single stock or currency profitably for your entire life.
What overarching strategy in terms of net exposure (long only or market neutral, e.g.)
Fundamental or Technical – on what basis will you select, rotate and replace your investments? How will you know if your M.O. is sound and workable? Are you a trader or an investor?
How frequently should you trade? How much time (and money) are you going to spend on investing and monitoring?
Most of all, do you think it will make you a happier person, experiencing a fuller life, considering not least the loss of time, and the gain (sic.) in frustration?
Check out my eBook for more useful information on investing, not least my ten most important lessons for any investor, private or professional, including the most important one:
Final note: This post doesn’t tell you anything about how to choose your actual investments, the actual stocks or instruments. That’s up to you. I’m ‘just’ telling you to be explicit about the framework within which to operate, and under which circumstances to abort.
Please share this article with your social network in order to help at least one person avoid financial ruin due to some simple error of omission.
Sub topic: 10 Investment/trading types – which one are you (really)
Bonus: Ex ante hindsight analysis, before smashing into the fan
Trader or thoughtful Investor?
Have you heard of the reverse prisoner’s dilemma?
Every second day, I walk to and from the gym on a narrow cobblestone path. It only fits one person at a time, or possibly a couple walking very closely together, in effect holding on to each other.
Right next to the path, on both sides, are irregular stones with gaps between, that are both difficult and dangerous to walk on – and hurts the feet even with shoes on.
Whenever two people meet on the path, both parties typically step to the side and walk past each other on the dangerous, stony side surfaces.
Both cooperate and both are worse off
Very rarely, a young kid or an old and decrepit person stays his course on the smooth cobblestone.
I know I could easily hold my ground on the path, but never do.
This is not a story about altruism; it’s about being aware of the world, analyzing it, discerning more or less useful patterns and making conscious decisions as a consequence.
It’s about knowing who you are and what context you act in. So…
What kind of an investor are you?
You may be a veteran and knowing both the market and yourself inside out. Or, you might be more or less new to the stock market game, making your strategy up as you go along.
No matter if you have decades of experience or just getting started, I would recommend systematically going over your investment style to see if it fits with your personality traits and natural talents.
Investing and trading is a lot like computer programming, weight lifting or consciousness. There are many levels of complexity not apparent to the untrained eye. Nested coding, self referential pattern repetition in gym periodization, and interest rates entering an investor’s equations from all sides.
These concepts and more (including Bach’s fugues, Escher’s impossible pictures and Gödel’s incompleteness theorems) are explored in depth in the wonderful, Pulitzer prize winning tome “Gödel Escher Bach” by Douglas Hofstadter. Keep that idea of increasing complexity and intertwinedness in mind as you browse the following (non-exhaustive) list of market strategies and the quality requirements of their agents:
10 investor types
HFT (High Frequency trading)
Financial power (in order to buy the fastest equipment there is)
Statistical genius for creating unique or fastest trading rules
Political clout (to avoid transaction costs, market abuse allegations etc)
Algo (HFT, MFT or LFT)
Unique insight into market dynamics; have to outsmart thousands of other algo traders
Strategy for changing market characteristics
E.g., the Kavastu Algo: “Have 100 different shares in the uptrend on the radar. Select the 40 sharpest for the moment and let them do the job. Then do the other things that are important in life during the day.”
Experience (market “feeling”)
Discipline (stop losses are essential)
Always on (hard to combine with a day job)
Long/short unbiased (to survive bear markets)
High overnight risk tolerance
If you don’t have time to be a day trader
If you lack short term market feeling
If you lack the patience or analytical skills of an investor
If you’re feeling lucky
This strategy sounds a lot like a loser strategy for all those that didn’t have what it takes for the other strategies. And yet, this would be my strategy of choice, if I wasn’t a long term, independent/contrarian fundamental investor
N.B., I’m not bad mouthing anyone or any strategy. If it works, it works. But does it, really?
Connected (to hear about and understand situations like mergers, acquisitions, product launches etc)
Up to date (on “everything” – no situation happens in a vacuum)
High loss tolerance (when a situation back fires)
Smart sizing strategy (to keep dry powder even after a few misses in a row)
Analytical (to outsmart hundreds or thousands of analysts trying to work out the next quarterly earnings and understand what other analysts and investors think and how they are positioned ahead of the next report)
Statistical/Mathematical (for finding new leading variables and combinations of variables in order to predict sales, earnings and others’ predictions)
Second level thinker (new product launches or rising earnings aren’t enough, the question is what others are expecting)
Very high overnight risk tolerance
Buy and hold
Extreme loss tolerance (draw downs in bear markets are gruesome)
Extremely detached (must be able to withstand pressure to sell when all the muppets are screaming at the bottom of a market cycle)
Extremely patient (If I’m right and a new bear market is just getting started, in 2016 or 2017 stock markets will be back at levels they first reached 20 years earlier)
Can’t stand seeing the neighbors become richer (if the worst thing conceivable is watching your neighbor buy cars, boats and jewellery for a few years during market peaks, you must Buy And Hold to guarantee you ride the market all the way up (and down again)
This is not really a strategy, but it kind of works anyway, for extremely dispassionate and pathologically long-term people
E.g., the Dividend Aristocrat: “Buy stocks with solid dividends and keep forever”
The so called Quattro strategy
Curiosity (there are many other asset classes than stocks, many other markets than your home market, and you have to be interested enough to find them, compare them, and put together your own pizza pie of investments)
Willingness to do some digging for annual portfolio re-alignment
Moderate personality; not impatient or greedy
This is the ultimate winner strategy – it doesn’t take super human or inhuman qualities or financial muscles. If you are a moderately curious and patient person with average finances, the quattro will keep making you a little better off every year, and probably keep pulling ahead of the energizer bunnies burning out on exertion and risk in most other strategies.
Fundamental long term investor
Patient (Markets swing wildly between extreme overvaluation and extreme undervaluation. If you keep buying once stocks get a little cheap and keep selling once they get overvalued, you’ll always feel over weight in troughs and under weight at peaks, but over time you’ll avoid the BAH-investors maddening highs and lows, while producing at least the same average returns
Analytical (You have to do all the work yourself to know when a stock or a market has strongly positive or negative return potential)
Mathematical (you do the math!)
Independent (contrarian) – sometimes you should run with the herd, sometimes against it. That takes a very unusual personality – rarely possessed by people with many childhood friends.
Couldn’t care less about peers or neighbors (“The Joneses bought a convertible, so what?”)
Loss tolerant. Period.
Doing it for fun
No analysis or research whatsoever
Sometimes trades on tips, sometimes on news, trends or whatever
Wastes money on commission but do about as well as any ape would – not too bad, but spends unnecessary amounts of time on performing a little worse than an index
Can you honestly say you possess the required qualities? Or could the harsh reality be that you are a fair weather trader that had a bit of luck during the last 6 years’ bull market?
What if you are impatient, loss-averse and not very analytical; a simple Buy The Dip trader with no real strategy or competitive edge? What if the moderate quattro is what really suits you best, but you are stuck in day or swing trading (due to beginner’s luck, and no desire to put in real work), or erroneously assume you’ll be psychologically and financially strong enough to hold on throughout a bear market trough?
My five cents on identifying your inherent investor traits
Go through your profits and losses. How did they come about. How did it feel? What if that near miss had been an actual miss?
Does your strategy or stock portfolio entail a single point of failure? Could something happen that would derail your lifestyle? Do you remember when drug lord Escobar had the luck of all the evidence against him burning up, since it was kept in one single, “safe” place? That was a single point of failure (SPOF) on behalf of the District Attorney.
Try this thought experiment: You have lost a lot of money. Assuming that has already happened, analyze how it happened and what to do to prevent it. Be creative.
Do you think low interest rates warrant higher asset prices? Day after day?
Then you are cooperating with central bankers who try to push up prices in order to kick start the market, and they are cooperating with you by keeping rates lower for longer, since all buying power is going into assets instead of consumer prices. Consumers postpone wage increases thanks to the wealth effect from houses and stocks.
The dance continues until it reaches a breaking point with collapsing asset prices and a sudden rush to cash, demand for higher wages to compensate for losses and rush to consumption when cash and wages eventually spark inflation.
Just like on my cobblestone path, all parties more or less unknowingly cooperate with each other, but everybody becomes worse off in the end. Faith in central banks will plunge, asset owners will lose money (albeit fake and inflated), consumers will suffer through a stagflation.
No harm no foul
As long as you know who you are, what kind of an investor you are, what your life is about, all the above is inconsequential for you. As long as you have matched your personality, your talents, your strengths and weaknesses to the actual threats and opportunities – and adequate targets – you’ll be okay.
Assuming you only participate in games where you have an edge (analytical, financial, psychological etc.), or games with only winners (quattro) and have set your targets in a self-aware manner, I’m sure you’ll come out on top.
Be careful what you wish for
As I advised a friend this summer, point targets are for losers and incremental strategies are for winners.
Aiming for retirement, financial independence or any such thing that depends on the final outcome is moot. Unless you enjoy the incremental progress, the journey in itself you’re highly unlikely to enjoy the end game even if you get there (and truly hate yourself and your life if you don’t).
Summary – be you, not a Jones
Are you a trader, an investor, analytical, patient, truly interested and capable, or do you just want to make some easy money?
Think carefully about what actually drives you, and match your traits to your portfolio (and life) strategy.
Avoid creating a single point of failure (in your life, as well as in your portfolio)
The end result of life (became rich, made it to old age) should only matter marginally for your total happiness compared to your appreciation of the process of getting there.
Investing is really complex and difficult. Take that to heart and think about what your competitive advantages are – or if you should choose a semi-passive Quattro strategy instead
Don’t silently “cooperate” by default; be independent and honest – at least to yourself. Remember that no Jones likes being beaten by another Jones. Just as it is street smart to let oneself be convinced by the other party in an argument, complementing on their wits, you’ll be more liked if you don’t keep up (ahead of) your neighbors than if you do.
Och om du är svensk ska du förstås lyssna på min podcast “25 minuter” (t.ex. på Soundcloud) som idag (9 november 2015) handlar om just att hitta sin talang. Glöm inte att prenumerera på kommande avsnitt i iTunes, Podcast Addict, Podcaster, Downcast mfl plattformar.