Essence of Portfolio Management

Essence of Portfolio Management

“The essence of investment management is the management of risks, not the management of returns. Well-managed portfolios start with this precept.”

– Benjamin Graham

The problem is many portfolio managers believe they manage risk through their investment selection. That is, they believe their rotation from one seemingly risky position to another they believe is less risk is a reduction in risk. But, the risk is the exposure to the chance of a loss. The exposure is still there. Only the perception has changed: they just believe their risk is less. For example, for the last thirty years, the primary price trend for bonds has been up because interest rates have been falling. If a portfolio manager shifts from stocks to bonds when stocks are falling, bonds would often be rising. It appears that trend may be changing at some point. Portfolio managers who have relied on bonds as their safe haven may rotate out of stocks into bonds and then their bonds lose money too. That’s not risk management.

They don’t know in advance if the position they rotate to will result in a lower possibility of loss. Before 2008, American International Group (AIG) carried the highest rating for an insurance company. What if they rotated to AIG? Or to any of the other banks? Many investors believed those banks were great values as their prices were falling. They instead fell even more. It has taken them a long time to recover some of their losses. Just like tech and telecom stocks in 2000.

All risks cannot be hedged away if you pursue a profit. If you leave no chance at all for a potential profit, you earn nothing for that certainty. The risk is exposure to an unknown outcome that could result in a loss. If there is no exposure or uncertainty, there is no risk. The only way to manage risk is to increase and decrease the exposure to the possibility of loss. That means buying and selling (or hedging).  When you hear someone speaking otherwise, they are not talking of active risk management. For example, asset allocation and Modern Portfolio Theory is not active risk management. The exposure to loss remains. They just shift their risk to more things. Those markets can all fall together, as they do in real bear markets.

It’s required to accomplish what the family office Chief Investment Officer said in “What a family office looks for in a hedge fund portfolio manager” when he said:

“I like analogies. And one of the analogies in 2008 brings to me it’s like a sailor setting his course on a sea. He’s got a great sonar system, he’s got great maps and charts and he’s perhaps got a great GPS so he knows exactly where he is. He knows what’s ahead of him in the ocean but his heads down and he’s not seeing these awesomely black storm clouds building up on the horizon are about to come over top of him. Some of those managers we did not stay with. Managers who saw that, who changed course, trimmed their exposure, or sailed to safer territory. One, they survived; they truly preserved capital in difficult times and my benchmark for preserving capital is you had less than a double-digit loss in 08, you get to claim you preserved capital. I’ve heard people who’ve lost as much as 25% of investor capital argue that they preserved capital… but I don’t believe you can claim that.Understanding how a manager managed and was nimble during a period of time it gives me great comfort, a higher level of comfort, on what a manager may do in the next difficult period. So again it’s a it’s a very qualitative sort of trying to come to an understanding of what happened… and then make our best guess what we anticipate may happen next time.”

I made bold the parts I think are essential.

If you are like-minded and believe what we believe, contact us.

The four most dangerous words…

Every new moment is necessarily unique – we’ve never been “here” before. Probabilities and potential payoffs change based on the stage of the trend or cycle. For example, the current decline in stocks is no surprise, given the stage and magnitude of the prior trends. A few see evidence of the early stages of a bigger move, others believe it’s different this time. We’ll see how it all unfolds. I don’t have to know what’s going to happen next – I am absolutely certain of what I will do given different conditions.

To quote from fellow Tennessean, Sir John Templeton:

“The four most dangerous words in investing are, it’s different this time.”

Sir John Templeton

Sir John Templeton

source: http://www.templeton.org

Each of us tends to think we see things as they are, that we are objective. But this is not the case. We see the world, not as it is, but as we are—or, as we are conditioned to see it. When we open our mouths to describe what we see, we in effect describe ourselves, our perceptions, our paradigms.”

–  The Seven Habits of Highly Effective People: Powerful Lessons in Personal Change by Stephen R. Covey, Quote Page 28 (2004)

Here’s to the crazy ones. The misfits. The rebels. The troublemakers. The round pegs in the square holes. The ones who see things differently. They’re not fond of rules. And they have no respect for the status quo. You can quote them, disagree with them, glorify or vilify them. About the only thing you can’t do is ignore them. Because they change things. They push the human race forward. And while some may see them as the crazy ones, we see genius. Because the people who are crazy enough to think they can change the world, are the ones who do.”

Steve Jobs

Steve Jobs

The person who says it cannot be done should not interrupt the person doing it.

– Chinese Proverb

The person who says it cannot be done Should not interupt the person doing it

Source: https://www.pinterest.com/explore/chinese-proverbs/

Adapting to change is a great quote, but not by Darwin…

adapt to change

“It is not the strongest of the species that survives, nor the most intelligent that survives. It is the one that is the most adaptable to change.

In the struggle for survival, the fittest win out at the expense of their rivals because they succeed in adapting themselves best to their environment.”

– great quote, but was NOT Charles Darwin

In 1963 Leon C. Megginson delivered a speech that contained a passage presenting his interpretation of Charles Darwin’s ideas. Megginson did not claim that he was quoting the words of Darwin. Nevertheless, over time, in a multistep process this passage has been simplified, shortened, altered, and reassigned directly to Darwin.

Source: http://quoteinvestigator.com/2014/05/04/adapt/

This is a great example of asymmetric information.

“We like what’s familiar, and we dislike change. So, we push the familiar until it starts working against us big-time—a crisis. Then, MAYBE we can accept change.”

—Kevin Cameron (Journalist, Cycle World April 2013)

Confirmation Bias: The tendency to search for, interpret, focus on and remember information in a way that confirms one’s preconceptions.

“It is impossible to produce a superior performance unless…

Sir John Templeton

source: http://www.templeton.org

A great quote from my fellow Tennessean, Sir John Templeton:

“It is impossible to produce a superior performance unless you do something different from the majority.”

Sir John Templeton

The One Thing: The Surprisingly Simple Truth Behind Extraordinary Results

I had a two-hour interview with someone yesterday (that will be available soon) about my firm and investment programs and found myself sharing a few of the same thoughts, over and over.

“Managing the ASYMMETRY® investment programs is all we do. I am fully committed and focused on this one thing: buying, selling, and managing risk in global markets to generate the positive asymmetry needed to compound capital positively within our risk tolerance”.

In a recent letter to our investors to reflect on the 10-year anniversary of my founding Shell Capital Management, LLC, I described the evolution of the firm, ASYMMETRY®, and myself over 10 pages. I called it “10 years of Shell Capital Management”; Christi called it “10 pages of 10 years of Shell Capital Management”! (When talking about these things, I have no short version!)

That’s because I’m fully committed and focused on this one thing we do. In that letter, I went so far as to say: it’s all I have, all I am, and all I ever will be. As I reflected on the past 10 years, it occurred to me that my whole life has revolved around this one thing. Without it, none of the other things, the lifestyle we enjoy, would exist. I believe my priorities are in line with reality. That has been a tremendous advantage for us.

Then this morning, I get an email from getAbstract: “Top 10 Summaries”, the 10 most downloaded getAbstract summaries in 2014.

The first on the list?

“Achieving great success in all aspects of your life calls for devotion to one single thing.”

The One Thing
The Surprisingly Simple Truth Behind Extraordinary Results

Gary Keller and Jay Papasan
Bard Press, 2013

the one thing The Surprisingly Simple Truth Behind Extraordinary Results

getAbstract goes on to describe it: (I highlighted a key part in bold)

“Gary Keller, co-founder of Keller Williams Realty and a best-selling author, overcame his own issues about focus, which makes his claims about cultivating better habits even more compelling. Multitasking isn’t fruitful, he says, since success requires long periods of laser-like concentration, not scattershot swats. If you find your “ONE Thing,” Keller says, everything else will fall into place. Keller, writing with co-author Jay Papasan, breaks his approach down into manageable steps based on research and experience. With an engaging writing style and plenty of bullet points, this reads much faster than its 200-plus pages”

It says the ONE Thing will bring your life and your work into focus. I obviously don’t need a book to tell me that, but it may help me understand myself better. I’ll be reading the abstract, but also listening to the audiobook version on Audible during my long walks in sunny Florida.

The Mistake is Not Taking the Loss: Cut Your Losses and Move on

One of the keys to managing investment risk is cutting losers before they become large losses. Many people have difficulty selling at a loss because they believe it’s admitting a mistake. The mistake isn’t taking a loss, the mistake is to NOT take the loss. I cut losses short all the time, that’s why I don’t have large ones. I’ve never taken a loss that was a mistake. I predetermine my risk by determining before I even buy something at what point I’ll get out if I am wrong. If I enter at $50, my methods may determine if it falls to $45 that trend I wanted to get in is no longer in place and I should get out. So when I enter a position in any market, I know how I’ll cut my loss short before I even get in. It’s the exit, not the entry, that determines the outcome. I don’t know in advance which will be a winner or loser or how much it will gain or lose. For me, not taking the loss, would be the mistake.

I thought of this when a self-proclaimed old-timer admitted to me he still holds some of the popular stocks he bought the late 90’s. Many of those stocks are no longer in business, but below we revisit the price trend and total return of some of the largest and most popular stocks promoted in the late 90’s. The black line is Cisco Systems (CSC), Blue is AT&T (T), Red is Pfizer (PFE), and green is Microsoft (MSFT). AT&T’s roots stretch back to 1875, with founder Alexander Graham Bell’s invention of the telephone. Pfizer started in 1849 “With $2,500 borrowed from Charles Pfizer’s father, cousins Charles Pfizer and Charles Erhart, young entrepreneurs from Germany, opened Charles Pfizer & Company as a fine-chemicals business”. At one point during the late 90’s “tech bubble” Microsoft and Cisco Systems were valued more than many countries. But the chart below shows if you did buy and held these stocks nearly 20 years later you would have held losses for many years and many of them are just now showing a profit.

tech bubble leaders 2014-11-15_07-04-53

chart courtesy of http://www.stockcharts.com

The lesson to cut losses short rather than allow them to become large losses came from a book published in 1923.

“Money does not give a trader more comfort, because, rich or poor, he can make mistakes and it is never comfortable to be wrong. And when a millionaire is right his money is merely one of his several servants. Losing money is the least of my troubles. A loss never bothers me after I take it. I forget it overnight. But being wrong – not taking the loss – that is what does the damage to the pocketbook and to the soul.”

-Reminiscences of a Stock Operator (1923)

If you are unfamiliar with the classic, according to Amazon:

Reminiscences of a Stock Operator is a fictionalized account of the life of the securities trader Jesse Livermore. Despite the book’s age, it continues to offer insights into the art of trading and speculation. In Jack Schwagers Market Wizards, Reminiscences was quoted as a major source of stock trading learning material for experienced and new traders by many of the traders who Schwager interviewed. The book tells the story of Livermore’s progression from day trading in the then so-called “New England bucket shops,” to market speculator, market maker, and market manipulator, and finally to Wall Street where he made and lost his fortune several times over. Along the way, Livermore learns many lessons, which he happily shares with the reader.

 

 

Markets don’t always react the way investors expect, so I focus on what is actually happening

hedge fund market wizards

I noted the below question and answer between Jack Schwager and Ray Dalio in Jack’s book “Hedge Fund Market Wizards: How Winning Traders Win” (2012). Ray Dalio is the founder of Bridgewater, the largest hedge fund in the world and one of the most successful. I saved it when I read the book as a fine example that markets don’t always react the way people expect, and that is why I focus instead on what is actually happening rather than what could or should happen – but may not. Everything is very transient, coming and going, and it’s funny how some of the same kinds of things happen over and over again. As you read comments below you’ll hear it’s always a similar story, different day. 1982 was the end of a 20 year secular bear market made up of huge swings similar to the past decade and the beginning of the largest bull market on record up to 2000.

Below is Jack Schwager asking a question to Ray Dalio:

Any other early experiences stand out where the market behaved very differently from what you expected?

In 1982, we had worse economic conditions than we do right now. The unemployment rate was over 11 percent. It also seemed clear to me that Latin America was going to default on its debt. Since I knew that the money center banks had large amounts of their capital in Latin American debt, I assumed that a default would be terrible for the stock market. Then boom—in August, Mexico defaulted. The market responded with a big rally. In fact, that was the exact bottom of the stock market and the beginning of an 18-year bull market. That is certainly not what I would have expected to happen. That rally occurred because the Fed eased massively. I learned not to fight the Fed unless I had very good reasons to believe that their moves wouldn’t work. The Fed and other central banks have tremendous power. In both the abandonment of the gold standard in 1971 and in the Mexico default in 1982, I learned that a crisis development that leads to central banks easing and coming to the rescue can swamp the impact of the crisis itself.

Source: Schwager, Jack D. (2012-04-25). Hedge Fund Market Wizards (pp. 54-55). John Wiley and Sons. Kindle Edition.

All of this, everything that is happening and expected to happen, will be reflected in the directional trend and volatility of price. The directional price and range of prices (volatility) will overreact at times and under-react at others, but it will reflect what is actually going on. Because the direction and volatility of price “is” what matters.

Trend Following Doesn’t Always Mean Crowd Following

“Trading has taught me not to take the conventional wisdom for granted. What money I made in trading is testimony to the fact that the majority is wrong a lot of the time. The vast majority is wrong even more of the time. I’ve learned that markets, which are often just mad crowds, are often irrational; when emotionally overwrought, they’re almost always wrong.”

Richard Dennis  (Famous Trend Follower)

 

Richard J. Dennis, a commodities speculator once known as the “Prince of the Pit,”. In the early 1970s, he borrowed $1,600 and reportedly made $200 million in about ten years.

To learn more about Richard Dennis, no one tells the story like Michael Covel in The Complete Turtle Trader.

 

Projection makes perception

The world you see is what you gave it, nothing more than that. But though it is no more than that, it is not less.… It is the witness to your state of mind, the outside picture of an inward condition.… Therefore, seek not to change the world, but choose to change your mind about the world.

– A Course in Miracles (T-21.in.1:2,3,5,7).

Is market timing [short-term trading back and forth among asset classes] really a good idea?

In October 2004, Jason Zweig interviewed Peter Bernstein for MONEY Magazine. The title was Peter Bernstein interview: He may know more about investing than anyone alive. Peter L. Bernstein was an early pioneer of tactical asset allocation thinking. He wrote about valuation-based asset allocation and being tactical in decisions rather than passive. He believed what I believe: we should take more risk when its likely to be rewarded and less risk when it is less likely to be rewarded. He published several books about it.

In the interview, Zweig asked:

“Is market timing [short-term trading back and forth among asset classes] really a good idea?”

Bernstein answered:

“For institutional investors, the policy portfolio [a rigid allocation like 60% stocks, 40% bonds] had become a way of passing the buck and avoiding decisions. The problem was that institutions had settled on a [mostly stock] asset allocation because in the long run, they concluded, that’s the only place to be. And I think the long run ain’t what it used to be. Stocks don’t have to do well in the future because they did well in the past. In fact, the opposite may be more likely.”

Source: http://money.cnn.com/2004/10/11/markets/benstein_bonus_0411/

Based on the chart below, which shows the Dow Jones Industrial Average (a stock index that cannot not be invested in directly) since that interview in 2004, I’d say Bernstein was right. Over the next decade, the stock index went on to gain 65%, but it dropped nearly that much along the way. That doesn’t seem to be the kind of asymmetry® that investors are looking for. If you look at it close enough, you can probably see why it makes sense to take more risk at some points, less risk at others. Though, it’s probably at the opposite times most investors do. So, most will advise investors not to try to do it. Like most things in life, some do it much better than others and have active track records that reflect it.

stock market index since 2004

source: https://stockcharts.com/freecharts/perf.php?$indu

Why Investors Fail

why investors fail

People believe they know things they don’t and focus their energy trying to know the unknowable, rather than focusing on those things we can know and can control. The problem starts with one of the most read and respected investment books.

“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.

-Benjamin Graham, “The Intelligent Investor”, 4 ed., 2003, Chapter 1, page 18.

The trouble with that statement is that it promises the impossible. That is, I believe all operations are speculative and we do best by treating them as such.

First, let’s define the terms, according to Merriam-Webster.

A promise is:

 “a statement telling someone that you will definitely do something or that something will definitely happen in the future.”

Analysis is:

“detailed examination of the elements or structure of something, typically as a basis for discussion or interpretation.”

Speculative is:

“engaged in, expressing, or based on conjecture rather than knowledge. (of an investment) involving a high risk of loss.”

So, to be sure we understand the meaning, let’s read it again and then interpret what it means using these definitions.

“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”

In other words, it suggests if you do a thorough examination of the operation, you will gain “safety of principal and an adequate return” and that will definitely happen in the future.

If you have ever wondered why so many don’t do well at investment management, this is one reason. They believe they can do thorough analysis up front that that will assure the outcome and protect against loss.

It doesn’t actually work that way.

We never know for sure in advance. And, if we focus on the things that do matter, we don’t need to know what will “definitely happen in the future”. The exit, not the entry, determines the outcome. The trouble with much of the value investing philosophy, whether buying private companies or exchange traded securities, is the assumption that you can determine what will happen next. But when you are so confident in that, you end up caught in a loss trap when you are wrong with no way out. Instead, the outcome is completely determined by our exit: how we get out of it.

So, I treat all operations as “speculative”. All operations have a high risk of loss.

And, all things are “conjecture”.

Conjecture:

“an opinion or conclusion formed on the basis of incomplete information.”

That is, we always have incomplete information. We never know it all. To me, it makes a lot more sense to focus on the direction prices are trending and know I’ll create my results by my exit, not my entry. I focus my energy on defining the direction and when it’s going in the wrong one… so I can exit.

etf managed portfolio

Impossibilities in the World

Who would believe the government of world’s greatest country, the United States of America, would shut down? And, since it did today, who would expect the Dow Jones Industrial Average would be up 65 points at noon? Portfolio management requires preparation and dealing with unlikely events – those that may even seem impossible. And then, accepting the things we cannot change. With that in mind:

einsteintongue

Impossibilities in the World

No matter how smart you are…

1) You can’t count your hair.

2) You can’t wash your eyes with soap.

3) You can’t breathe when your tongue is out.

 

Put your tongue back in your mouth, silly!

It’s a Beautiful Morning even when it’s not…

Learning isn’t the same as being taught

I think an independent thinker learns what he or she wants to know, while others must be taught. For example, the most intelligent humans are those who didn’t need someone to teach them formally, they are the first to figure things out. Our society often relates the most learned people by what college they attended and how much of it, but what if someone instead read over 500 books on subjects like math, scientific research, psychology, and trading? You may consider that the developers of the best systems and the products we love didn’t necessarily create them at a university or after earning an Ivy league degree. They are instead the ones teaching the world new things that they are able to develop and understand in ways most people can’t. Others go to the classroom hoping to understand some of the basics taught by books and lectures. The greatest things are discovered by deep independent thinking.

Intelligence: has been defined in many different ways including logic, abstract thought, understanding, self-awareness, communication, learning, having emotional knowledge, retaining, planning, and problem solving.

Leaning isn't the same as being taught

Source: When the student is ready, the master appears. ~Buddhist Proverb

If you have a question or comment to me directly, contact me. If you want to reply for everyone to share, reply below. If you like this post and want to share it with others, click on the Twitter, Linkedin, below.

The essence of investment management is the management of risks…

“The essence of investment management is the management of risks, not the management of returns.”

– Benjamin Graham

The problem is many portfolio managers believe they manage risk through their investment selection. That is, they believe their rotation from one seemingly risky position to another they believe is less risk is a reduction of risk. But, risk is the exposure to the chance of a loss. The exposure is still there. Only the perception has changed: they just believe their risk is less. For example, for the last thirty years, the primary price trend for bonds has been up because interest rates have been falling. If a portfolio manager shifts from stocks to bonds when stocks are falling, bonds were often rising. It appears that trend may be changing. Portfolio managers who have relied on bonds as their safe haven may rotate out of stocks into bonds and then their bonds lose money too. That’s not risk management.

They don’t know in advance if the position they rotate to will actually result in a lower possibility of loss. Prior to 2008, American International Group (AIG) carried the highest rating for an insurance company. What if you rotated to AIG? Or to any of the other banks. Many investors believed those banks were great values as their prices were falling. They just fell more. It has taken them a long time to recover some of their losses. Just like tech and telecom stocks in 2000.

All risks cannot be hedged away if you pursue a gain. If you leave no chance at all for a potential profit, you earn nothing for that certainty. Risk is exposure to an unknown outcome that could result in a loss. If there is no exposure or uncertainty, there is no risk. The only way to manage risk is to increase and decrease the exposure to loss. That means buying and selling or hedging.  When you hear someone speaking otherwise, they are not speaking of active risk management. For example, asset allocation and Modern Portfolio Theory is not active risk management. The exposure to loss remains. They just shift their risk to more things. But they can all fall together, as they do in real bear markets.

It’s required to accomplish what the family office Chief Investment Officer said in “What a family office looks for in a hedge fund portfolio manager” when he said:

“I like analogies. And one of the analogies in 2008 brings to me it’s like a sailor setting his course on a sea. He’s got a great sonar system, he’s got great maps and charts and he’s perhaps got a great GPS so he knows exactly where he is. He knows what’s ahead of him in the ocean but his heads down and he’s not seeing these awesomely black storm clouds building up on the horizon are about to come over top of him. Some of those managers we did not stay with. Managers who saw that, who changed course, trimmed their exposure, or sailed to safer territory. One, they survived; they truly preserved capital in difficult times and my benchmark for preserving capital is you had less than a double-digit loss in 08, you get to claim you preserved capital. I’ve heard people who’ve lost as much as 25% of investor capital argue that they preserved capital… but I don’t believe you can claim that. Understanding how a manager managed and was nimble during a period of time it gives me great comfort, a higher level of comfort, on what a manager may do in the next difficult period. So again it’s a it’s a very qualitative sort of trying to come to an understanding of what happened… and then make our best guess what we anticipate may happen next time.”

I made bold the relevant points.

If you are like-minded and believe what we believe, contact us.

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