Horizon Kinetics’ 1st quarter commentary has an excellent primer on “On Concentrated Positions, “Locking in Profits” and “Trimming”” which contains sage wisdom, well worth reading (pages 2-6).
When trying to summarize my own investment strategies in a sentence, it always amounts to maximizing the reward/risk ratio (or minimizing the risk/reward ratio). Most laymen when hearing this think it means trying to operate a conservative-as-possible portfolio, but it doesn’t preclude really swinging the bat for a home run now and then at the risk of a strikeout. However, when going into detail as to what exactly entails ‘reward’ and ‘risk’, I end up sounding like a total flake simply because my investment style is to be as amorphous as possible dealing with the cross-section of the highest probability of what I believe I know (e.g. I can’t know everything, I don’t know most of everything, I know a lot of what I do not know, and I don’t necessarily know what I think I know!) and where I think things are going in the grand scheme, and having political experience helps with this. Markets inevitably are human-driven, with all of our psychological traits deeply embedded despite most of the actual trading being driven by human-written yet computer-executed algorithms.
It is always disturbing to me that the performance I have generated over the past 15 years or so has just could have (Sacha’s note: In the original posting, I forgot to include these two words which materially alters this sentence!) been the result of dumb luck. I’d like to think otherwise, but I can’t rule it out. One great and bad thing about an “amorphous” investing strategy is you can’t backtest it to measure how much alpha you truly generate. But I do like the “if I went into a coma for the past X years, would my portfolio be better off today or had I not slipped into the coma” test, whereby you can measure your performance against yourself rather than some arbitrary index. For instance, all of us have underperformed the bitcoin index over the past decade.
If I were to characterize the markets currently, it is pretty clear that things have stabilized after Covid-19 and this is going to end up muting overall returns going forward. Q2-Q4 in 2020 was a bountiful time where farmlands were fertile, and today the crops are growing, but the harvest time is coming very soon. I’m guessing that as the more youthful participants in the markets slowly get their accounts liquidated (through SPACs, junk crypto and the like), that the remaining competitors in the market will be much more sharper with their pricings. The continuing gap of passive vs. active (another topic that Horizon has written about extensively in the past) will also be exploitable going forward.
I don’t like this primer much. Some thoughts below:
Excellent counter-arguments.
Indeed, unless if one has some mechanism where you can determine which winners to let run, you get exactly some other counterexamples of capital destruction. I used Worldcom as an example in a prior email to somebody on this, and also used dot-coms, and mortgage companies leading into 2008.
Also one has to determine which range of companies to invest in to generate at least one prospect of a company rising in value in a material manner, it could be the case that a portfolio full of 50 assets, none will appreciate (e.g. 100% SPAC portfolio, or all of the crap-coins out there).
And why the obsession with Bitcoin? Why not Ethereum, Ripple, or whatever? One of my initial counterarguments as to why Bitcoin is a flawed investment is the ‘counterfeit’ angle, i.e. somebody can cut and paste the codebase and make their own digital currency. Dogecoin is a great example. But what do I know, BTC’s north of US$50k.
I think Bitcoin is flawed because it is useless. It solves nothing except the non-problem of banks being intermediaries in transactions (substituting an army of servers owned by unknown parties operating under code written by an unknown person or persons). The facts that it is an energy disaster, clunky at best and subject to vaporizing in cyber attacks (or when an owner simply forgets his code) are secondary.
I suspect that Bitcoin and its useless cyber cousins are allowed to continue to exist for a few reasons. One is that regulatory action will fuel the paranoia of the converted. Another is that cybercurrency is actually somewhat helpful to central banks in mopping up excess liquidity injected into the markets (takes inflationary pressure off of real assets). When this usefulness ends, watch out. This is ironic because the crazy converted think things are working the other way around.
Does bitcoin really take out excess liquidity? For every buyer there’s a seller, and doesn’t that just transfer that liquidity?
For every $ bid to buy bitcoin, a $ is not bid on another asset. Therefore, at the margin bitcoin is a disinflationary force for other assets. If the bid on bitcoin goes to zero, the wealth bitcoin holders thought they had vaporizes. No different that paying $1M for a hockey card and then lighting it on fire.
I disagree. Lighting the hockey card is more energy efficient.
Very true and it is possible to enjoy it in the spokes of a bike wheel first! Also, it has the bonus effect of making other hockey cards more valuable.
This comment doesn’t really apply to growth companies where the value may be rising as fast or almost as fast as the price.
This is fair point related to the example but not the main idea. For a company growing intrinsic value at the same rate as the market price, the reward is not changing. What about risk though? Is it decreasing?
Where the intrinsic value growth is outpacing market price, we may indeed argue that the reward is increasing. But risk? I suggest that finding real world examples of risk/reward improving as market prices rise is much rarer than the opposite. TSLA is $666 today (a very fine number to illustrate the evil in Horizon’s approach haha). If it rises to $1332, is anyone going to seriously argue that the risk/reward calculus has halved (required in Horizon’s never-sell, lucky-penny approach)?
One basic component of investing is WHAT to buy. Another is HOW MUCH. In a risk/reward based approach, the HOW MUCH can, and ought to be, reconsidered frequently based on changing market prices. If our approach tells us that 10% is the maximum portfolio position for a company, then to allow it to go to 20% better be backed by something a lot stronger than mark-to-market pricing.
Interesting thoughts. My approach to diversification is different than most people’s. I believe in diversifying at cost not market value. So I don’t trim or rebalance as my account becomes skewed. If one of my stocks grew to 50% after many years of holding it, I wouldn’t sell any to “rediversify”. I believe that if you diversified at purchase you are always diversified and trimming is not just unnecessary but harmful to long term results. I’ll sell it if I don’t like the company anymore or if the price has gotten really extreme, but not just because it’s been working. I don’t expect anyone to agree with me on this 😉
Good discussion. Rod, just curious, does your no-rebalancing policy apply to companies in obviously cyclical industries?
I don’t usually buy highly cyclical companies, but if I did buy one I think I would still not worry about rebalancing–If I thought the industry had entered a boom period and the stock price was far too optimistic I’d sell. But I wouldn’t sell just because I’ve made money. I’d sell because the price to value ratio had turned to crap.
I think trimming is about fear of developing a large exposure to something. I don’t fear that. I think it’s an inevitable consequence of success. Like if an entrepreneur started five businesses and one of them took off and the others didn’t, would anyone expect him to sell part of the business that’s working and put more time into the duds because the successful one is becoming too important?
“ I’d sell because the price to value ratio had turned to crap.”
Isn’t this just a variation of my point about risk/reward? Why wait for it to go to crap? Why not subtle trims to maintain the right amount of exposure for the risk?
“would anyone expect him to sell part of the business that’s working and put more time into the duds because the successful one is becoming too important?”
Why would anyone rotate money into duds? Why not into a higher and better use based on risk/reward?
“I think trimming is about fear of developing a large exposure to something.”
Exactly. God help those Bre-X investors that, unnecessarily, lost nearly everything.
It probably is a cruder variation of your approach. Maybe I’m less of a believer in making subtle moves. Do you feel it’s been a benefit? I’ve never found subtle adjustments to add anything personally. I think there have been times I’ve shifted money from one stock to another and just as often the one I sell goes up more. I can see it working if you are dealing with highly illiquid stuff. I sometimes trade around those positions when the opportunity is there. But generally, I just treat my investments as independent bets that operate on their own life cycles. I buy when I think I’m getting a great deal and hold long enough to sell at full value.
I’ve modelled it out. If we buy at a low price and sell at higher one AND it goes up in a straight line. Trimming along the way at ~5% increments will result in making ~HALF the profit.
Show me a stock that goes straight up and never wiggles a bit 🙂
In a long term hold (measured in many months or years), if we trim as the stock goes up and buy back on dips, we can claw back that lost upside (and potentially add much value) while at the same time managing risk. In a diversified portfolio, there is almost always something to buy with the funds. In measuring the impact of this on my portfolio (through analyzing outcomes), I believe it adds 3-6% to overall portfolio returns.
I don’t understand Horizon’s penny example. They assume the index will earn the future mean return of all stocks (6%). It won’t. It will be higher. Indexes are usually market cap weighted so will experience the same positive skew as the buy and hold account. Stocks in the index that perform better will become a larger part of the index over time.
Agreed the index is basically a similar approach in letting the winners ride. However, if you plot the S&P against the S&P equal weight index on stockcharts back to 2003 the equal weight returns far exceed the market cap weighted index. Even from last year’s sell off the equal weight outperformed the index which goes against the narrative that the market gains have only been in the big boys at the top of the index.