There were two things on my mind recently:
- Living with a transition from a concentrated strategy to a more diversified strategy.
- Proper position sizing versus the risk of ruin.
As a student of the game, it is always illuminating to hear about how money managers handle the finer details of investing.
I was reminded of two interviews Joel Greenblatt did that explains these two disciplines separately. Joel Greenblatt wrote a series of highly popular investment books, runs Gotham Capital and teaches investing at Columbia University.
Why did Joel transition from a Concentrated Investment Strategy to a much more Diversified Strategy?
Joel and his partner used to run a very concentrated NET-NET portfolio where 8-9 holdings will make up more than 80% of his portfolio. It is not uncommon for him to wake up one day and see some of his picks not working out. The portfolio will be down 20-30% due to that.
Around the 2000s, they tried and experimented with ways to buy not just cheap businesses but good and cheap businesses. This was due to the influence of Buffett on the quality factor.
By then, Joel have been teaching his students at Columbia University about investing in good and cheap companies.
From 2002 to 2003, they hired a programmer to do research on good and cheap companies. The first test they ran was a crude screen of 50% valuation and 50% return on tangible book value. The back-tested returns were fantastic.
They didn’t start out with trying to find the best way to make money but to test what they could achieve with some crude metrics (as explained above).
To Joel, this was a great way to share the implementation of the things he has been teaching his students.
This wasn’t the best thing to make money but was certaintly powerful enough for him.
It also set off a light bulb in his partner and his head.
If they apply their fundamental sophistication to the metrics, could they build a better model?
They managed to and eventually resumed taking outside capital again in 2009.
They discovered that if they developed a diversified long and short style strategy, it makes more money with less volatility than if they do a concentrated style strategy.
They chose to long 300-400 and short 300-400 from a basket of 3000 stocks in their diversified strategy. In contrast, a concentrated strategy entails doing the same but with 50 stocks.
The reason the concentrated strategy underperformed was that the concentrated strategy became much more volatile during certain periods such as 1999-2000 because the strategy also involves leverage.
Eventually, Joel felt that why he chose this strategy was a matter of preference. He was successful with both.
A diversified strategy allows him to work with a larger research team, follow more stocks and not subject his portfolio to the kind of drawdowns experienced with the concentrated portfolio.
Joel thinks that investors with certain temperament are more suited to certain strategies (not everyone can sleep well at night if its not uncommon for your portfolio to run 20-30% drawdowns in retirement)
Position Sizing is About Impairment Management
Joel was asked about his thoughts on position sizing and this is what he says.
Joel feels that position sizing is an important question.
Suppose you identified this great investment and you decide to put 2% of your capital into the position. If this position goes up 50-100%, you would have blown the position.
That could turned out to be your worst investment of all time because you should have had a 10-20% position and that would have moved the needle. (Joel mentioned that if that position was Tesla, which went up 10X, that 2% position would have moved the needle.)
Position sizing is the most important thing.
Being too timid about the few good ideas that come your way is the biggest mistake people make.
But of course, to take a large position, you have to be willing to be wrong, take big losses, to wait for that big position to know when it’s there.
The biggest positions he had are not his best ones, which is the positions that will go up 5X or 10X.
Often he is prioritizing controlling his risk than looking at the upsize when he is taking a big position.
In other words, Joel will size the position larger if he does not think he would lose much money. It’s not like the thing that’s going to pay 10 or 20 times.
Obviously, if you have a $10 stock, that’s sitting with $9 in cash and no debt, and they have a little business attached, we can buy a lot of that company, as long as we think the company won’t waste that cash. That kind of concentrated position may turn out to be a good asymmetric bet.
Joel explains that risk is not in an event such as COVID or 2008, when companies like Lehman goes down, a group of stocks can trade at any price.
His definition is whether a reasonable person can pick their spot to sell a stock over the next couple of years and won’t lose much money. They should think about what is the worse that could happen to that position. After that, they can then think about how much reward they could earn relative to this risk.
Joel then cite the example of buying a house.
A housing purchase often is the biggest purchase we can make. A house will be a large part of your net wealth and your salary, compared to a lot of other things.
Some people will be hesitent to purchase because they would think: “How much do I think I could lose at this investment?”
Instead of looking at the full lump sum, you can frame that you would be risking only 10-20% of the full value of the house.
If you frame it that way, you may be able to sleep better at night.
I think both interviews were helpful to me.
I could transition to another strategy, but I got to determine with enough confidence that the strategy will work just as well as if not better than the previous strategy.
Better may mean a better risk-adjusted return.
There are different degree of ruin for different stategy. For some investors, they do not understand the spectrum of volatility of the strategy they implement. So they either size too small (risk-averse) or too much (risk-seeking thinking things won’t go wrong or stonks only go up).
I might have overestimated the potential risk of ruin of my strategy way too much that it becomes detrimental to the portfolio. This is something that I got to re-evaluate and fine-tune.
I invested in a diversified portfolio of exchange-traded funds (ETF) and stocks listed in the US, Hong Kong and London.
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