I’ve been thinking…
Last week, a client asked me how I’ve been spending my time this quarter. The answer to that, given the recent drawdowns, is that I’ve mostly been spending time re-evaluating our current portfolios and hunting for new opportunities. I’ve also, however, been thinking a lot. Specifically, I’ve been thinking about position sizing, hedging, and trading. Here’s what I’ve been thinking…
Position Sizing:
Position sizing is hard. When markets are good, you think your position sizes are too small and when the market is bad, you think your position sizing is too large. You can size based on conviction but you’re going to be wrong ~50% of the time. You choose to add to positions as the company executes, but when market dislocations happen, you find you can’t add more as you’ve already committed all the capital you can to that position. Some investors believe in equally weighting all initial positions, but that implies the potential opportunities for each of your investments is the same. On the flipside, investing based on potential IRR is popular but IRRs change as facts change, and IRRs are rarely realized in a straight line. Some investors feel you should always let your winners run, but then you must deal with outsized positions which can really hurt in the short run (just talk to anyone who had a 20%+ position in tech stock going into 2022, for example).
I don’t think there is really a right answer about position sizing and to a large extent the correct path comes down to risk tolerance, strategy, time horizon, and goals. However, I’ve been thinking that:
No position should be so small that if it doubles it has a negligible impact on the portfolio.
The flipside to the above is that smaller positions are not an excuse to be lazy about diligence (both initial and ongoing). A 60-70% drawdown will hurt your portfolio even if the position is small.
Start a position on the smaller end, and then scale up into it as the company executes but leave enough buffer to buy more during that inevitable drawdown (40%+). You also don’t truly know a company until you’ve invested in it, so scaling is prudent.
No position size should ever make you lose sleep (what makes you lose sleep is down to your risk tolerance). This doesn’t mean just size alone, but size in respect to potential risk. i.e even a medium sized position in a Russian stock would have made you lose sleep this last quarter.
Despite what I said above, potential IRRs are still a good way to determine eventual sizing, however it should be weighed against geographical risk. A potential 20% in a Chinese tech stock and a 20% IRR in a US tech stock are not the same, as we’ve learned.
Conviction is good, but it shouldn’t become your religion. Many theses take years to play out, and that leads to opportunity cost (are you early or wrong?).
Let your winners run but remember the ‘don’t lose sleep’ rule.
Hedging:
Hedging is hard. Hedging by buying options can be capital-effective with downside limited to the premium paid, but timing it is difficult. If you don’t get it right, time value erodes against you quickly. You can choose to buy longer-dated options, but then the premium goes up and so does the size of permanent capital loss. Shorting is another option, but is not for the faint of heart, just ask anyone who has tried to short meme stocks – or ask Bill Ackman. Shorting has high borrowing costs and also has diminishing returns. Shorts get less effective over time, thus you constantly must find new ones. Buying natural hedges (commodity ETFs, gold, etc) are a way to deal with time value problem of options but require substantial more capital to make an impact on your portfolio. However, I’ve been thinking that:
Options are useful when there is a potential major/catastrophic risk on the immediate horizon. The event may not come to fruition, but if it does, intrinsic value will skyrocket without the countereffect of eroding time value. If nothing happens, then your capital outlay is limited to the premium spent.
That said, think twice about using options for longer-term hedges. They are expensive and require timing. If you get it wrong, risk of permanent capital loss is high.
Natural hedges are probably more prudent but require a large capital outlay. Also they can do absolutely nothing for years (ehem.. gold). So be prepared to have 5-10% of your portfolio to not add any value for a while.
I’m still not brave/smart enough to short, nor do I think it is necessary given our strategy. I’ll leave that to the hedge funds.
Trading:
Trading is hard. If you were a good trader, you had an edge during the last few months. Being able to sell your positions in November and buy them back in March would have benefited you greatly. But trading requires a certain understanding of momentum, sentiment, and technical analysis. In general, good investors make bad traders and vice versa. I’ve always dismissed trading as being relevant in an investing paradigm, but as volatility increases, the more appreciation you get for it. However, I’ve been thinking that:
You should trim when sentiment is starting to deteriorate, when narrative shifts, or when significant adverse news comes out (granted you have to decide the difference between actual adverse news and noise). Even if price recovers, the story has changed, and thus you need to be more prudent.
There’s little point selling when sentiment has already tanked (like we saw in early March), a bounce can happen at any time.
Buy back when you least feel like buying back. This is typically when sentiment highly negative, and the thought of buying makes you nervous and philosophically ill.
I’ve also been thinking that investing is hard. This quarter’s market madness has shown that. But as the saying goes, ‘Never let a good crisis go to waste.’ The volatility has helped sharpen up my thinking and develop guidelines that should serve us and our clients well in the future. Investing is hard, but this market dislocation has opened up ample opportunities for us to be able to take advantage of. Investing is hard, but it sure is exhilarating and despite ‘bad times,’ it is also extremely rewarding.
Thanks for reading, and as usual, happy investing.