Divestor

The question of how large a position to take in various securities has generated a lot of literature in financial academia. I won’t bother repeating it here, but specifically, the analysis deals with how to mitigate systemic and non-systemic risk, and diversification is one method to reducing non-systemic risk.

The concept is pretty simple – if all your eggs are in one basket, if you drop that basket then you are hooped. But if you have two baskets then you at least still have half your eggs left in case if you trip.

I noted on Gannon on Investing (somebody that writes very well and comes from a similar background as mine in Finance, mainly through self-teaching) that he believes in big concentration. Specifically, he wrote the following:

My Most Controversial Investing Belief: Extreme Concentration Works

I buy very few stocks. Again, this comes from personal experience. By far, the worst losses to my portfolio came in years where I held the most stocks. The best performance came from 25% or bigger positions in my portfolio that I chose to hold longer term.

I’ve made a lot of money by:

Sticking around for the buyout
And having more than 25% of my portfolio in the stock when that buyout came

Today, I would never buy a stock that makes up less than 10% of my portfolio. I prefer not to start a new position unless it is expected to eventually be 25% of my portfolio. I am not interested in owning more than 5 stocks at a time. I’ve done it – like with Japanese net-nets. I may do it again in similar basket type situations. But I’m a lot less likely to. So, basically I own 4-5 Warren Buffett type stocks (in terms of competitive position) bought at Ben Graham type P/E ratios.

Right now, I’m looking for a European stock to put 25% of my portfolio into. It won’t be 5 European stocks at 5% each. It’ll be one at 25%.

I will distill this principle in another manner: an individual investor can only spend so much time researching securities. Very frequently this process can be as laborious as going through a hundred companies and then throwing all of them on the watchlist and not do anything because they are trading at incorrect valuations. When you do finally have a “hit” that reaches your hurdle rate with an appropriate margin of error, why should you take something that you’ve deemed to have a good risk-reward ratio and dilute your own investment research with a small position size? Good opportunities don’t come often, so why not pounce on it with two feet when they occur?

Personally, my own position sizes are determined by my own perception of risk and a slight modification of the Kelly Criterion. If the risk is high (which would require the reward component to be extraordinarily high), then you keep your bet size small. If the risk is low, then you can afford to concentrate without incurring a blow-up. Probably the best example in my own investment history was putting a large position on Rogers Sugar (TSX: RSI) back during the middle of the economic crisis. It was a classic example of a low risk, medium reward type situation where you can afford to put capital to work.

Ultimately estimating the risk is quite an art because you also have to factor in risk that you never would have conceived of. For all publicly traded companies, such risks include management fraud, accounting misstatements, an earthquake ripping through the corporate headquarters, a plane crash with the executives on board, etc. This alone is probably a good enough reason why I wouldn’t go far above a 20% position size.

That said, if that starting 20% position doubled in your portfolio, it would become 33% of your portfolio. Learning how to pare concentrated positions that have grown due to appreciation is a skill. While I have tended to have decent skills on my entries, I still haven’t mastered the art of selling profitable positions – I typically am one to leave the party early.

Finally, the academic rules concerning position sizes tends to revolve around the management of large portfolios rather than individual investors applying their niches on the markets. The rules of diversification change when running a billion dollar hedge fund versus a relatively smaller portfolio.

Given the high amount of cash in my portfolio, it is always tempting to allocate more cash than usual into new positions, but that is a sure-fire way of losing money.

While making election predictions is not the focus of this website, making political calls is something that I would consider to be in my core competency, and my guess is that the people of Greece will be giving a plurality of votes to the anti-austerity party, SYRIZA. My prediction is that they will receive 22-25% of the vote and with the 1/6th seat bonus that the top party gets in the legislature, this will put them at 39-42% of the seats in the Greek parliament.

This will require them to make a coalition with one of the other parties in order to have any hope of forming government. In this respect, 39% is a lot different than a 42% result – 39% will require them to form government with the socialist PASOK, but 42% will give them more freedom to likely work with one the other minor parties and strike up the best deal with them from a position of negotiating strength. If they cannot form government, the other parties are sure to not form government and there will be yet another election.

What this means in the macroeconomic scope is that there will be yet further uncertainty in Greece and this will translate into continued focus on Greek domestic impact on the entire EU.

I am of the suspicion that macroeconomic market participation will be relatively quiet until the results of the Greek parliamentary election is known on Sunday.

Today was clearly a “risk off” day. After the EU had all the “good news” by extending another $100 billion to Spain which enabled them to kick the can down the road for another few months.

I will use spot WTIC crude as an example, but really, this could have been a chart for any of the major indicies and bond yields:

I always play this imaginary game with myself: looking at just one intraday chart and then extrapolating how the rest of the market fared in the day. Financial wizards call this “correlation”. Basically you can see how the entire commodity market (minus Gold and Silver) did by just looking at the Canadian to US dollar ratio. If the Canadian dollar strengthens, its a pretty good sign that commodity markets are up.

Today, with crude down, clearly the Canadian dollar will be losing purchasing power. The fun, however, is looking at individual issues and picking out the semi-liquid ones that have gotten taken down with margin calls. I still don’t see signs of too much distress in the non-AAA/AA/A Canadian corporate debt markets at the moment, unless if you’re an investor in Yellow Media.

I’m waiting to pounce for the day that I can deploy this cash, but it is still not here.