The Portfolio MYTH-----Do you need to change your thinking?

[DeepState]

Deepstate real life rarely works that way, who can honestly say they estimate the future prospects of all stocks in their portfolio to be equal? Lets assume that your portfolio stocks had unequal (by your own judgement) prospects and that the 100 bagger stock even after rising 100 fold had the best future prosoects ? What would you do then? Ben Graham in his Graham Newman partnership kept the outsized hlidng in GEICO and eventually spun off the holding to shareholders, many of whom continued holding it. So the type of scenario I describe does have historical precedent (the numbers were different but the essence of the scenario was the same).

Then I would rebalance the portfolio in line with the future prospects as I judge them to be, taking in to account some notion of risk. To the extent that this portfolio differs to the current one, I would consider rebalancing to the target. Rebalancing is about bringing your portfolio back in to line with objectives and prospects rather than letting the market carry it around. In general, it's a good idea. Someone will always find a way to screw it up.

 

[Value Hunter]

A concrete example of diversification versus concentration by the same person is the hunter hall funds. The Hunter Hall high conviction trust launched a few years ago hit the ball out of the park with stellar performance by Peter Hall. The fund clearly showcased his ability with the fund sometimes having as few as 5 stocks and at one point (from memory) St. Barbara goldmining was more than 30% of the portfolio. You compare that to other other Hunter Hall funds which were highly diversified and had mediocre performance over the same time frame you can see how the burden of having to pick many stocks dramatically weighed down Peter Halls performance.

 

[Value Hunter]

Craft, maybe you make lots of mistakes with your assumptions because you own too many stocks ;-)

 

[DeepState]

A concrete example of diversification versus concentration by the same person is the hunter hall funds. The Hunter Hall high conviction trust launched a few years ago hit the ball out of the park with stellar performance by Peter Hall. The fund clearly showcased his ability with the fund sometimes having as few as 5 stocks and at one point (from memory) St. Barbara goldmining was more than 30% of the portfolio. You compare that to other other Hunter Hall funds which were highly diversified and had mediocre performance over the same time frame you can see how the burden of having to pick many stocks dramatically weighed down Peter Halls performance.

Awesome.

 

[craft]

Craft, maybe you make lots of mistakes with your assumptions because you own too many stocks ;-)

Maybe I make them because I'm just a mere mortal who can not see the future.

 

[Value Hunter]

Deepstate were you being sarcastic?

 

[luutzu]

Deepstate were you being sarcastic?

Dismissive.

 

[Value Hunter]

Deepstate here is a question for you.

Travel back in time to the 1st of December1989. Let's assume you did not know the future. Let's assume you were a Japanese investor and worker living in Japan. Let's say your work pension\retirement fund offered you a chance to invest your retirement money in option A or option B. Lets further assume you could not rebalance or alter your choices for the next 25 years nd that no money would be added or withdrawn from the funds (any dividends or capital returns would be reinvested though). Option A was a fund replicating the Nikkei 225 and option B was an equal weighted portfolio of Nestle, 3M and Coca-Cola. Which option would you have chosen? Which option was more risky?

The point I am more making is that owning more stocks is not per se less risky than owning fewer stocks. It may or may not be less risky. It depends. You have to consider a wide range of factors.

 

[Quant]

Got 3 key words " Worst Case Scenario " thats your risk , dont make the risk ruin ... close the thread

 

[DeepState]

Deepstate were you being sarcastic?

Refer post #8 for the relevance of "Awesome" and Hunter Hall High Conviction.

Deepstate here is a question for you.

Travel back in time to the 1st of December1989. Let's assume you did not know the future. Let's assume you were a Japanese investor and worker living in Japan. Let's say your work pension\retirement fund offered you a chance to invest your retirement money in option A or option B. Option A was a fund replicating the Nikkei 225 and option B was an equal weighted portfolio of Nestle, 3M and Coca-Cola. Which option would you have chosen? Which option was more risky?

The point I am more making is that owning more stocks is not per se less risky than owning fewer stocks. It may or may not be less risky. It depends. You have to consider a wide range of factors.

As a Japanese investor...investor...I'd actually see that the banking system was destroyed by the Plaza Accord and buying a market with a PE that can't fit on my scientific calculator screen is not a good idea. In all likelihood, I would have held Japanese government bonds and cash plus a bunch of global stocks and bonds in some proportion that made sense to me at the time. I would probably hold some gold as well as my confidence in the entire Japanese monetary situation would have been compromised.

I am side-stepping your question. Both A and B are dumb options with which to force me in to a binary decision.

 

[Value Hunter]

So Deepstate based on your above post we are both in agreement that diversification by itself is not necessarily sufficient to create a sensible portfolio , that many other factors come into play.

My point is that blind diversification without proper thought is not going to magically solve everybody's problems. There are certain specific scenarios where a diversified portfolio may be riskier than an ultra concentrated portfolio. That being said I concede that on average a diversified portfolio is less risky. Are you willing to concede that in certain specific scenarios a diversified portfolio can be riskier than an ultra concentrated portfolio?

 

[craft]

Deepstate here is a question for you.

Travel back in time to the 1st of December1989. Let's assume you did not know the future. Let's assume you were a Japanese investor and worker living in Japan. Let's say your work pension\retirement fund offered you a chance to invest your retirement money in option A or option B. Lets further assume you could not rebalance or alter your choices for the next 25 years nd that no money would be added or withdrawn from the funds (any dividends or capital returns would be reinvested though). Option A was a fund replicating the Nikkei 225 and option B was an equal weighted portfolio of Nestle, 3M and Coca-Cola. Which option would you have chosen? Which option was more risky?

The point I am more making is that owning more stocks is not per se less risky than owning fewer stocks. It may or may not be less risky. It depends. You have to consider a wide range of factors.

VH

How about you flip this question for yourself but make the decision point today, throw into the mix option C) of just owning CCP. What would you do?

Then jump in your time travel machine and travel forward 25 years and tell us how it turned out.

 

[Value Hunter]

Craft in the scenario you described I would choose option B with the 3 stock portfolio. I am fairly confident Credit Corp will do well over the next 5-7 years but 25 years out is too long to foresee for this type of business. I do not expect to be holding Credit Corp in 25 years time and its the type of company which does not have that sort of huge most and you have to watch carefully for any signs of detioration and be ready to sell, whereas companies like Nestle and Coca Cola and 3M you could be reasonably confident would be worth a lot more in 25 years time. If however the question was a 5 year time horizon I would choose Credit Corp.

 

[Value Hunter]

To answer the second part of the question in 25 years time Credit Corp could be the biggest debt collection company in the world or it could be bankrupt. I would not be able to tell. 3M, Coca Cola and Nestle with dividends reinvested would all be nominally worth at least quadruple (probably more) what they are today and the Nikkei225 would be higher than it is today but would substantially lag the 3 stock portfolio.

The above is of course just my best guess.

I am curious Craft out of options A, B and C which one would you choose and why?

 

[minwa]

A 3 stock portfolio of across 2 industries that I can possibly live with, 4-5 across 4-5 industries would be much more attractive. Very different to one stock.

You are picking the next few best (in your opinion) which should only slightly under perform your best single pick (assuming your opinion turns out right and your single pick is the best performer) - tiny "sacrifice" to make for a proportional large reduction in blow out risk.

 

[DeepState]

So Deepstate based on your above post we are both in agreement that diversification by itself is not necessarily sufficient to create a sensible portfolio , that many other factors come into play.

Yes. Was that not evident?

Did I ever say that diversification in and of itself finds a cure for cancer or would solve the Korean peninsula arms escalation issue? All I have argued is that one and two stock portfolios require pretty special circumstances to be sensible, let alone heavily levered ones.

These situations do exist, but are very uncommon. There is no law against it. Hang on. You can get heavily fined for it and fall into significant disrepute if you advise retirees to do it. So maybe there is a law against it.

Inadequate diversification is a problem when better options exist. But most people, including some seemingly smart ones, would have no idea as to the cost to their wealth or investment mission from inadequate diversification in real life situations as opposed to investments so long term as not to matter in one life-time.

That being said I concede that on average a diversified portfolio is less risky. Are you willing to concede that in certain specific scenarios a diversified portfolio can be riskier than an ultra concentrated portfolio?

I am willing to concede that I made this statement several posts ago to that effect.

Stock numbers per se are just the most obvious way of talking about diversification, but it is a proxy for some concept of effective diversification. What is wanted is maximum reward for risk and an appropriate deployment of risk.

What matters is risk adjusted return. Simply put, if you take more risk than you need to for a given view of the world, that's just plain dumb. I'm not going in to the concept of effective diversification any further than to say it is actually the target matter on the risk side of risk-adjusted return (which, for the pedantic, includes a utility function that can be as bizzare and multi-universal as you like so long as someone actually doesn't like losing money in general), as opposed to some magic stock count that solves the world's problems.

 

[craft]

The above is of course just my best guess.

Awsome

I am curious Craft out of options A, B and C which one would you choose and why?

None - I hoped by referring the question back to you, you might perceive some things about the futility of hindsight and prediction.

 

[Value Hunter]

What matters is risk adjusted return. Simply put, if you take more risk than you need to for a given view of the world, that's just plain dumb. I'm not going in to the concept of effective diversification any further than to say it is actually the target matter on the risk side of risk-adjusted return (which, for the pedantic, includes a utility function that can be as bizzare and multi-universal as you like so long as someone actually doesn't like losing money in general), as opposed to some magic stock count that solves the world's problems.

How do you quantify risk or risk adjusted returns for a simpleton fundamental long only investor? You keep discussing in a way that gives an impression that its some mathematically quantifiable thing that you just plug into a formula. Please break it down with a concrete example in a way that a simpleton like me can understand. To me is risk analysis is a judgement call that combines quantitative and qualitative factors and there is no formulaic or mathematical way of calculating risk.

For example I use my own analysis and judgement, coupled with reference to history, etc to decide how many stocks to own, how much to invest in each, holding period, use of leverage, etc and have no rigid rules. How do you decide how many investments to own, how risky they are, how long to hold, and how much to invest in each? Please provide a concrete hypothetical example explained in a dumbed down way so I can understand.

 

[Value Hunter]

Craft, anytime anybody invests in anything including cash we are making predictions about the future whether implicit or explicit so for you to imply that prediction is futile seems strange. Craft when you pick individual stocks as we all know you do you are implicitly predicting that over the long run the sum total of your picks will outperform the market (if you did not believe this you would have put all of your money in index funds). Or am I misunderstanding you?

 

[DeepState]

How do you decide how many investments to own, how risky they are, how long to hold, and how much to invest in each? Please provide a concrete hypothetical example explained in a dumbed down way so I can understand.

How do I decide? It is the outcome of a quadratic optimisation which takes my views about the expected returns on assets or clusters of assets and builds portfolios subject to tracking error or total volatility limits. These volatility estimates are estimated generally via principal components analysis, and either GARCH processed or Bayesian shrunk to a diagonal matrix, after front weighting, depending on the purpose. The reasonableness of this is tested against the implied volatility of the market itself and my knowledge of events that might make this inaccurate. Then, there are hard limits put in to place to prevent corner solutions from dominating outcomes. These hard limits are often aware of what the stock or the cluster of assets actually does for a living. Where the return outcomes are still subject to strong tail events, I hedge or insure them in some way. When all of this is done, the stock number and portfolio composition pops out and I put it in to the market.

I own lots of different things, not just stocks. I would represent the other extreme on the issue of portfolio diversification, but what I do is not normally found outside of multi-strat hedge funds which makes it uncommon from the outset. I have certain skills and this is how I apply them.

Although I use lots of maths, I also take the radical step of....actually checking if the output makes any sense. Why might the training window not be reasonably representative of the forecast window?

In general, my thinking is strongly influenced by risk parity and risk budgeting concepts, though adapted for my circumstances.

At present, I have no idea about how to explain this simply and don't feel particularly motivated right this minute. Howard has some ideas for estimating risk for single assets or, otherwise, strategies for trading them. Perhaps that's a good place to start.