Divestor

I do note with amusement that a former Member of Parilament’s “real estate bubble” website is advocating some strangely risky financial strategies. Apparently he has forgotten that ETFs derive their value from their underlying holdings, which contain precisely the amount of risk that he declares that people with only a million dollars and above should be engaging in. Here’s my phrase of the day: Diversification is for investors that don’t know where to find value. Diversification also does not mitigate against systemic risk, as most investors in the second half of 2008 discovered.

If your portfolio size is a modest fraction of annual after-tax income, putting all your eggs in a single basket (i.e. putting it all on a very well-researched company) is an acceptable strategy if one believes in maximizing both their risk and reward. As the portfolio size appreciates above annual income, maximum position sizes need to be trimmed down to avoid what I call “blowup” risk, but financial academics call unsystematic risk. With commissions as low as they are, people can invest reasonably with as little as $5k – with $10 commissions, you can diversify into five positions with a 1% expense ratio, or better yet, choose two and keep your expense at that of a typical index fund.

Especially for young people, it is vitally important to learn how to lose money in the public marketplace before making money – making mistakes that cost you 20% of your portfolio means a lot less when you have $5k in the account than $500k. You learn exactly the same lessons, but with a lot less money.

The worst thing that can happen to a beginning investor is that their first three trades are wildly successful.

One of the tricks that you learn in the marketplace over a decade of experience is that you make money by buying when things go lower, and sell when things go higher. It sounds awfully cliche, but doing this correctly is an art and will never be a science – sometimes the markets do something “crazy”, and taking advantage of craziness is how you make a substantial sum of outsized gains – whether it is buying at a crazy low, or selling at a crazy high.

While I would not call present conditions crazy, I do consider them frothy and have been lightening up positions since the beginning of September. Having a high fraction of the portfolio in cash is always boring, but I am fairly firm in my belief that cash will be outperforming most asset classes after the winter is done. There is just not enough reward out there for the risk. I still have enough in the market to participate in further gains and to profit in case if things do become “crazy”.

Until then, I wait. Boring, boring, boring.

If I had to select people to manage my money, there are only two people that I can think of that I would trust sufficiently to generate good performance – James Hymas and David Merkel. One can easily tell by how they write that they have very disciplined and narrow-focused techniques for generating market-beating performance.

On Merkel’s site, he has a small gem of a paragraph which seems to be quite relevant to increasingly aggressive investors that are chasing yield at any cost:

[…] total return matters more than current income. Income can be generated by liquidating small amounts of funds expected to underperform.

Apparently hordes of retail investors are out there just looking at the “dividend yield” number and using that as a basis for investment, which it should only be used to determine how effective management is at allocating capital. For example, if you have a debt-laden company that continues to give out distributions far beyond cash flow generation, it is probably a good sign you shouldn’t be investing in that company.

Investors in many income trusts that went public during the 2006 income trust mania learned this lesson.

(Addenda: I wonder how long it will be before you have “experts” trying to get retail investors to sell covered calls on their equity portfolios for additional income.)