CategoryPortfolio management

There are a lot of tools available for doing asset allocation of your portfolio. They vary from the simple (like 90- age should your equity %) to the highly complex which try to allocate assets based on age, risk profile, asset classes etc.

I have till date never used an asset allocation tool though. I don’t say this with any pride or due to some big insight. It is just that I am not comfortable with most of these mechanical tools.

Asset allocation according to me is a highly subjective process. My thought process has been a bit different on it. I don’t look at asset allocation just from the point of view of my investments alone. For me an allocation decision depends on some of the following factors

1. amount of money saved – I had a higher equity holding earlier when my asset base was small. However as time progressed my equity holding as % of assets have come down although the absolute number has gone up
stability of my day time job – there have been times when I have felt that my primary source of income has been at risk. At such times I have tried to reduce the risk to my portfolio by not increasing equity investments

2. opportunities – A lot of my asset allocation decisions are based on what seems undervalued. I tend to migrate my portfolio in that direction at that time. For ex : 2002-2003 was a time for me to increase my equity holding. 2003-2004 was the time for me to move into real estate (which was based more on need than any timing). 2004-2005 was the time for me to go long on debt and into floating rate funds. 2005 and onwards I have not done much, expected liquidate a bit and just read.

3. Experience or learning – I tend to invest in only those asset classes where I feel I have some understanding and a bit of an edge. As a result I have never dabbled in options, metals etc

4. Whims and fancy – I would like to think I am rational, but I guess I am more risk averse than an average investor. As a result my investments are smaller than what a mathematical formuale (such as kelly’s formulae) would suggest. In addition, I have an aversion to IPO’s (more in a later post), gold and in ,general commodity business.

5. Sleep test – this would seem to be the most irrational factor, but it is a very important one for me. It works this way – With the current asset allocation , can I sleep well in night if a particular asset drops by 20-30 %. I have at time liquidated assets that don’t meet this criteria.

As a result of all these factors my average equity holding fluctuates between 30-50 %, real estate 20-30% and the rest in debt holding. Not a very optimal approach, but it gives me my targeted rate of return and lets me sleep well !!

My earlier tendency when adding a stock to my portfolio was to allocate an arbitrary amount of money to it. The actual bet or the size of the position was initially a fixed amount of money and later it became a fixed percentage of the portfolio (around 5 % usually).

However later I read several articles and charlie munger’s thoughts on investing and have modified my approach. After I have identifed a stock and am willing to commit money to it, I try to evaluate how confident I am about the stock. I try to quantify this confidence level in terms of the margin of safety, which is the discount at which the stock is selling from the intrinsic value of the stock. So if the intrinsic value of the stock (as calculated by me) is 100, and if the stock is selling at 60, then the discount is 40%. So higher the discount or margin of safety, higher my confidence.

In addition, I try to calculate the odds on the stock too. I use the following formulae to calculate the odds

Intrinsic value (under most optimisitic assumptions of growth, profit margins etc) – current price / (current price – intrinsic value (under most pessimistic conditions)

So my cut off in terms of odds is 3:1 and I typically look at stocks selling at a discount of 40% to intrinsic value. The above may seem to be very stringent criteria in terms of selecting stocks, especially under current market conditions. But this criteria has served me well, as I am able to build a huge margin of safety in my purchases. Ofcourse I am using the above criteria for my long term holdings.

My bet or size of the position is generally 2% or 5 % and a max of 10% if my level of confidence is very high. However I am not into portfolio balancing. So if my best idea has done well and is now say 20% of my portfolio and I think is still undervalued, I let it run and remain in the portfolio. The only time I would sell would be if the fundamentals of the company deteriorate or the company becomes highly over valued.


Side note : Just read that capital account convertibility may be introduced in india. That could have major implications for all of us as investors as it is possible that we may be allowed to invest out of india. I think currently we can do that with a limit of 25000 usd, but it is with restrictions. Lets see what kind of freedom the capital account convertibility brings in. I am however optimistic and excited about it.

The above may sound strange. Ofcourse, warren buffett has famously said that large amounts of capital act as an anchor on investment results, but then it is more so for the professional investor and certainly not for individual investors like us.

But I have different viewpoint and it goes like this. For me investing is more of risk than return. Before I look at the likely returns, I tend to look at what I could lose under the worst case scenario. Now the worst case scenario for an individual stock is ofcourse 100%. But it likely that during a market downturn, the portfolio can drop by 25% or more (even for a conservative investor)

It is under these conditions that the portfolio size becomes important. How much is the portfolio as a % of your networth? If it is 20-25 %, I can rationally handle a loss of upto 50%. But if the portfolio is 100% of my networth, I think I would not be rational if the portfolio drops by 50% or more. I could very likely panic and sell at the bottom. Now you may feel that you would not react in that fashion and it is quite likely. But believe me, if you are one of those who started investing seriously in 1998-99 and saw your portfolio go down right upto 2003, you would have wondered when it would end.

Ofcourse looking back at 2003 now, feels like april/ may 2003 (the lowest point of the indian market) was a wonderful time to start investing as the great bull market was ahead of you. But if history was any guide at that time, the market has gone nowhere in the last 10+ years and one had to have the conviction to hold onto and better add to your portfolio at that time (with a negative performance to boot!). It is precisely for this reason that I am conservative in my approach and once I have a few years of experience and have gone through atleast one bear and bull market will I increase my equity portfolio as % of my networth.

So next time when you hear some one brag that he had fanatastic return last year on his portfolio, ask him what % of his networth has he put into equity and has he gone through a bear market with that percentage. If he/she has a high % of networth in the stock market, has had a fanatastic run in the last 2-3 years and is feeling that he/she is the next warren buffett, smile and better, pray for him that he pulls out before the next bear market.

So what if one is levearged and has more than 100% in the market and has seen only the bull market. Unfortunately these are the people who hit the headlines when the market tanks.

Michael J. Mauboussin recently published a paper on the legg mason website called ‘size matters’ on the Kelly criterion and importance of money management.

The paper is slightly technical on probability and an extremely good read. The key point of the paper is that investors should use the kelly criteria of defining the optimum bet size based on the edge or information advantage one has over the market. The formulae is very simple, namely

F = edge/odds

Where F is the percentage of portfolio one should bet. Edge being the expected value of the opportunity and odds being gain expected from the opportunity.

So if one has a meaningful variant perception or edge over the market (translating into a positive expected value) and expects to win big, then the above formulae helps in deciding the size of the bet as a percentage of the portfolio.

In simple terms, if one’s expected value (probability of gain*gain+probability of loss*loss) is high and the gain is also high, then one should bet heavily.

Conceptually I find the above approach very compelling. My own approach has been the similar. For example, if I am confident of a stock (after all the necessary analysis), I tend to allocate a higher amount of money. My definition of low, medium and high is around 2 % , 5% and 10 % of portfolio for a single stock.

Ofcourse the above approach is sub-optimal and would not lead to highest returns over a long period of time. It is not that I have a problem with the formulae. My problem is how do I know that my ‘edge’ is really an edge. Ofcourse whenever I have put money into a stock, the unstated assumption is that I have an edge. but then i invested in tech stocks in 2000 thinking i had an edge. Although I have a quantitative approach of going for a high expected value with a 3:1 odd, I cannot be sure.
So to safeguard myself (against my own ignorance, risk aversion or stupidity or whatever you can call it), I tend to adopt a suboptimal approach which gives me lower returns, but lets me have sound sleep (I have sleep test for risk, if I lose sleep on something, then it is too risky)

But irrespective of how one executes the above concept, it is a very sound one and should be followed to manage risk prudently

I am reading a fairly enjoyable book ‘A Mathematician plays the stock market’ (see section ‘currently reading’ under sidebar). Found the discussion on geometric mean v/s arithmetic mean (for returns) fairly relevant for an investor.

Let me explain

Arithmetic mean (or returns) is the simple average of returns over the time period being considered.

For ex: consider a stock X that has the following returns for the year
Week 1 : + 80 %
Week 2 : -60 %

The average return for a two week period is +10%. The ‘average’ return for the year would be 1.1^52 = 142 times the original investment. If average return is what an investor gets, then anyone can be fabulously rich in no time.

Geometric mean of the same stock will be derieved by the following formulae
Total return = (1+0.8)*(1-0.6)*(1+0.8)…….( for 52 weeks) = 0.000195

The scenario in the above formulae is that the investor makes a positive return the first week, followed by negative the next and then positive and so on. So the real return he/she actually gets is less than 1 % of capital invested

Another example
An investor is on the lookout for a hot mutual fund. He looks at the mutual fund rankings and sees a fund, which has returned 100 % last year. He invests his money in the fund. The hot fund promptly proceeds to lose 50% next year ( reversion to mean or maybe bad luck ).

The return the fund publicizes is 25 % (average for 2 years ). An investor who was invested for 2 years is lucky to get his money back. The performance chasing investor looses half his money. The fund manager and his company get their asset management fee and are able to show great performance at the same time.

Reminds me of a famous title of a book – ‘where are customer’s yatch?’

There is another interesting discussion happening on the BRK board on MSN (registration required ) on the same topic.