ROGER HIRST: Welcome to the workshop on Portfolio Construction and Risk Management. Now, hopefully, you've already reviewed the previous parts of this module, and you have an idea of some of the key concepts. But what many would-be investors love to do is browse charts and search for great trade ideas. But then when it comes to discussions about risk management and portfolio construction, interest levels often drop off a cliff.
And yet, risk management and portfolio construction are perhaps the most important part of the whole investment process. You can be a great stock picker but a terrible portfolio manager at the same time. So you need to know what risks you can take. You have to think about the right expression of a trade. And you really should understand how you manage your entry and exit points and how you think about sizing a trade, both compared to the size of your investment portfolio and your overall career wealth.
And we'll obviously touch on the joys and the dangers of volatility and leverage, as well as outlining the importance of diversification, which means not having all your eggs in one basket, which still might be the case, even if you have multiple different positions in your portfolio. So this workshop outlines some of the core principles to building more robust portfolios. This really is the part which can make or break performance. And so we think that this workshop is of particular value to all investors, traders, and entrepreneurs.
We've mentioned this before, but it's absolutely worth mentioning it again. If you're going to be a good risk manager and avoid the many pitfalls that await you in markets, then you absolutely must understand your lesson objectives and your attitude to risk . And let's be real, investing is a bloody difficult pursuit, and you must be prepared to accept losses in order to generate long term performance. But the first rule of investing is still to be around to trade again next year. And risk management is all about ensuring that by striking a balance between having sufficient exposure to realize your return objectives without blowing up your portfolio in the process.
A lot of this will depend on your psyche and, ultimately, your lifestyle factors. If I was approaching retirement, I probably wouldn't be going gung-ho with directional bets and leverage, trying to achieve double digit returns. Capital preservation, and perhaps tracking a few stocks, as more of a hobby would likely be enough for me. If I was in my late 20s or early 30s and without the financial commitments of a family, I would probably have both time and earnings power working in my favor, which means that I can afford to take more risks with the capital that I have.
So the way that you approach the market should really be based on your income, your outgoings, and your ability to recover from losses. And time is a really important factor in this equation too. Having time on your side should enable you to recover from losses and also compound growth to achieve your investment goals more easily. Or as Einstein is often wrongly attributed with saying, compounding is the eighth wonder of the world.
But there are, of course, individual circumstances that might mean that you approach things differently to me, even if I were in a similar position in life to you. For example, I spoke about my preference to focus on fewer positions rather than lots of individual trades. So if you work long shifts or travel often, or have other commitments demanding a lot of your time, then there might simply not be enough hours in the day to keep on top of a portfolio of, say, 50 positions. Or day trade, like Dave Floyd and Peter Brandt, which requires to be bolted to the chair pretty much all the time.
On the other hand, you might be fascinated by the challenge and find that you are easily bored if you don't have enough going on. So it's your investing style which needs to be adapted not only to your objectives and risk appetite, but also to your lifestyle.
So let's start by looking at constructing a single trade or investment before we move to building a portfolio of them. So let's say, you've generated an investment hypothesis following your understanding of market drivers, asset classes, and following the price action on charts. The next step would be to express that idea through a specific security. Now, what do I mean by that?
Well, expression. An expression relates to the security that you select for your investment, based on the view that you hold. For example, if you are bullish on the economy, then you could buy cyclical stock, or copper, or maybe emerging markets, or maybe even short the bond market. But firstly, you should figure out the time horizon of your idea, and then express the idea for an investment that has the same time horizon. So remember that Paul Tudor Jones quote. Make sure your idea horizon matches your trade horizon. And that's very, very important. So you might actually want to write that one down.
So if you are bullish on the economy, what is the best expression of that view? Well, in reality, it isn't likely to be only one. It all depends on your specific view, the risks that you're willing to take, and also what else is in your portfolio. And also, be mindful of what it will cost you to express that view. So for instance, if you're going to short bonds, well, that means you're going to be charged the borrow cost on the bond that you've borrowed to shorten the market. Plus, you're also on the hook for the coupon, and you may have to pay a margin requirements as well.
Therefore, ask yourself, is there a less costly way to express or carry that same view. And that's where the expression "cost of carry" comes from. As Harris Kupperman said in a previous video, when he is bullish on a commodity, he prefers to buy the commodity and not have to pick a stock that comes with other risks around company management, politics, jurisdiction, and often a lot more. You can buy gold outright, or you can buy the ETF of gold mining companies, or the ETF for junior gold mining companies. Or you can pick a specific large or junior mining stock.
Now, on the surface these trades will have the same core driver, and that's the price of gold. But the outcomes might be very different, as each of them contains numerous different risks. And it's all about that risk reward. And sometimes, the risk is just too much for the potential given reward. You can apply the same sort of logic any time you're trying to express a new idea.
But we can also take this one step further. Instead of going long the shares of the company, we could buy a call option for a limited risk position with embedded leverage and that same unlimited upside as we would have with the underlying shares. And whilst there are more sophisticated options strategies that you might want to employ, the principle of expression is the same. The aim is to see whether you can get more bang for your buck by trading a different instrument to express that same core view, which you can achieve through limited risk positions, volatility, and leverage.
And remember, I talked about that gold trade in 2012 to 2013, where it looked like buying puts was the best way to express the view. But the Federal Reserve was going to withdraw liquidity, which would then have a negative impact on gold, or so was the expectation. And so by recognizing not only the macro set up, which would see gold fall, but also the relatively low volatility in the options market, we got cheap downside exposure via the options. Shorting gold or gold stocks might have worked, but would likely have required more capital and a high cost for the same result. So again, be very mindful of those costs.
OK, so now we've got that out of the way, and we've selected the best expression that matches the time horizon of our idea, what's next? Well, let's take a look. James gave a prime example of how not to do it in his Bitcoin trade following the Fed's emergency stimulus in response to the pandemic in March 2020. His idea horizon was that Bitcoin would rally over the next 12 months, along with reflation and other risk assets. He got long just above 4,000 but only held the trade for a matter of days, as a rapid 50% gain felt too good to be true.
He was still bullish on a 12-month idea horizon, but it failed to match that in his trade horizon. Exactly one year later, Bitcoin was at a record high above 60,000. Now obviously, with some hindsight bias, what could James have done differently?
Well, at this point, you might want to pause and just think about this for a second. Knowing that James didn't need cash for something else but was just making a somewhat emotional asset allocation decision from Bitcoin into gold, we can probably infer that he was worried about the volatility of crypto markets. if he was worried about the thesis in general, he would have taken his money out instead of deploying it into another security. And on that basis, it sounds like he was not following his idea horizon.
But he might actually be experiencing a position sizing issue too. James felt uncomfortable with the potential volatility of his position, and even though his long term view is unchanged, he wanted to protect his profits. A few ways he could have reduced volatility but stayed in the trade-- again, with that hindsight bias-- is he could have closed his initial Bitcoin position and only kept the profit he made invested. That would have reduced his sides by 2/3 and allowed him to sleep better at night, while still being in the trade. And Mark Ritchie talked about this. Who knows what could have happened later as the market calmed down?
Alternatively, he could have closed his initial Bitcoin position and invested the initial position back into gold. This would have lowered his volatility, and given gold's performance, he would still have been pretty well off. So as you can see, sizing a position is a very important lever in the trade construction equation. So let's take a closer look.
Position sizing is one of the main aspects that often sees people fail to stick to their intended horizon. Experience tells us that you never have a big enough position when a trade is working for you. And you usually feel that you have too much on as it goes against you. Now, unless you get this right, then you'll be tempted to take a trade off too early. It might be out of boredom in switching to something else if your position is too small, or sleepless night if your position is just way too big.
And there are a few ways that you can do this, but the pros often size their positions according to volatility. If an asset is more volatile, like Bitcoin, then we should consider taking a smaller position to compensate for this. And if we're looking to trade something with relatively low volatility, such as the currency like the euro, then this will guide us towards taking a larger position. And this is what professionals refer to as volatility adjusted position sizing. That aims to equalize the movements across the positions that you have.
And the easiest way to measure volatility is using a study called the average true range. It determines an asset's typical volatility over a specific period. The standard look back is 14 days on daily charts or 14 periods, depending on your time frame of your chart. Here's an example using Bitcoin.
The average true range can be seen in the lower panel. If we take this number and divide it by the current price in the upper panel, then this will give us the average for Bitcoin in percentage terms. And you can convert it into a percentage to make it easier for comparisons with other instruments, such as the euro. And if I wanted to risk a proportional amount of my portfolio in both trades with a base amount of, say, 2% of my capital, then I factor this by the relative volatility of the two assets.
If the average true range percent is four times greater for Bitcoin than it is for the euro, then I will scale down my position accordingly to 0.5% in this example, which is 2% divided by a factor of 4. Of course, if you're only trading equities, then your comparison might be the ATR of a given stock relative to the index.
And at this point, we should also bring in entry and exits as part of the conversation, as they will play a very important role in determining your size. The saying is that timing is everything. And markets certainly have a way of telling you when you've got it wrong. Bad execution will end up costing you money, whether you initially bought too high or got out too late. You need to the levels where you want to be in and out of your position and also where to re-evaluate as time progresses.
I talked about the hedge fund client who'd wanted to trade on one of my ideas and printed out a chart and asking me to draw a line on where his entry and exit level should be. And this is the thing. It's essential that you know this in advance, because once you're in the trade, it's all too easy to lose your way and fail to act decisively.
In an earlier module, we talked about how technical analysis can be used to identify areas of support and resistance. And it can also be applied here to define our entry and exit points. Stan Druckenmiller talked about his short of the euro versus the US dollar following the ECB's decision to go to negative interest rates back in 2014. As he mentioned in a previous video, he usually tries to open a trade with 1/3 of the intended size. This allows him to feel the market. And then upon a technical break, he presses his bet.
In this case, he opened the position at 1.39 and pressed upon a break of the head and shoulders top at 1.35, right at the top of the longer term descending trend. This idea of incremental sizing, starting small and then scaling in the position as it goes your way, is something mentioned by numerous other traders, like Pierre Andurand, Mark Ritchie II, and a lot of others. Whilst this is just a hypothetical example, it hopefully demonstrates the concept of identifying your entries and your exits in advance and where to re-evaluate things along the way.
And the key takeaway here is how trade expression and time horizon, as well as position sizing and timing, can drastically tilt the odds further in your favor. At the very least, they will keep you in the game for longer until certain things become more natural. So now, let's zoom back out and look at the full portfolio.
When we think about portfolio construction and risk management, there are three related concepts to think about-- diversification, hedging, and leverage. Diversification mostly boils down to correlation of outcomes in the broadest sense of the word. You want to make sure the success of different parts of your wealth are as independent as possible. It all starts with how you define your wealth. Your job, your business, your mortgage, your stock portfolio are mostly correlated to the business cycle.
If you work at a tech company and you have stock options, your wealth will be heavily correlated to the tech sector. And when you think about your investment portfolio, first and foremost consider the rest of your life, i.e., your total wealth. Then within your investment portfolio, you need to look at the fundamental drivers of each position. Is everything just a different expression of the same theme? Risk on versus risk off? Or are the ideas actually different?
You should also consider your diversification across counterparties. Should you hold all your money in one bank or broker? Well, it depends, but it's certainly something worth considering. And some risks are actually hedged by picking the right expression for your trade. If you don't want political risks, you probably shouldn't buy stocks in emerging markets with questionable political regimes. And look at other ways to play that theme.
Within stocks specifically, you can utilize different varieties of spread trades to isolate some of those risks. For instance, you can buy a sector and short the market index to express positive relative sector views and hedge out that market risk. Alternatively, you can buy a sector and sell another sector across a sector spread that hedges the market risk again. And finally, you can buy a stock in a sector and sell a stock in the same sector, which is an interest sector spread that hedges sector and market risk, but contains two idiosyncratic risks in those individual shares.
And we also heard Jamie describe how he managed his portfolio as a long-short equities manager, focused on the insurance industry. He was running relatively long-short positions in insurance companies, and for the most part, eliminating market and sector risk and only focusing on relative valuations of those companies. He spoke about GMV, or Gross Market Exposure, which is effectively the total exposure of both the long and the short bets combined.
And this is different to the net exposure, or NMV, which was longs minus shorts. Gross exposure gives you an idea of your total portfolio size. If you have $100,000 gross exposure on $50,000 of capital, that means you're leveraged 2 times. But the net exposure is what most professionals will refer to, as the netting off of shorts against longs should reduce your market exposure and/or your sector risk.
To ensure that he was truly market neutral, meaning zero net exposure, and therefore effectively hedged, Jamie would also take into account the relative sensitivity of his positions to the market, or the beta. A bit like in the earlier example using the average true range and relative volatility when sizing your positions, if the beta across all your longs is greater than the average beta of your shorts, then you would still be net long with $100,000 long and $100,000 short.
If the market sensitivity of your long positions was, say, 2 times greater than that of your short positions, that means a 1% drawdown move in the market will generate a 2% loss on your longs and a 1% gain in your shorts. As you can see here, you're not properly hedged. You'll need to either cut your longs by 50% or increase your shorts by 100%.
And as discussed, correlations tend to break, and adding more positions only complicates everything through leverage. Sometimes the best tool for hedging is actually reducing your overall portfolio exposure, your GMV, if the volatility regime has shifted, or just in that particular position. And if you're looking to hedge the position, sometimes the cleaner answer might be to scale down that position or just remove it altogether. So therefore, when in doubt, always go for simplicity.
And don't forget, having no position is also a position. It gives you optionality and freedom of mind to plan your next move. You don't need to always make hero trades. Those are for the ego. Always focus on P&L.
And now, on to leverage. Leverage is the silent killer in all of this, and you need to be aware of what you're getting yourself into. But used wisely, it can be an effective tool. But if you get carried away with it, then even small mistakes will be magnified, and it could end up with you being completely wiped out. Leverage to a novice investor is like speed to a novice driver or skier. It opens you up to hidden complexities and puts more pressure on your decision making capabilities.
When it's a sunny day and you're driving on a well-maintained straight road without traffic, adding speed probably won't be a problem. But if it's raining hard, and there's fog, and there's holes in the road, and there's considerable traffic, well, that's when you're in trouble. The more leverage you have, the more favorable the conditions need to be for everything to work out well. You don't have to look far to find examples of some extremely high profile disasters that came about through the misuse of leverage.
For instance, take Long Term Capital Management, LTCM, which is founded by two of the allegedly smartest people to have ever worked in the industry, Myron Scholes and Robert Merton, who won the Nobel Memorial Prize. So therefore, at this point, please note, there can be a vast gulf between the theory and the reality when it does come to working in financial markets.
And therefore, despite their apparent intelligence, a net returns ranging between 21% and 43% in the first three years of the fund's operation, LTCM lost over $4 billion in as many months due to their highly levered positions that were hit by the Asian and the Russian financial crises. And more recently, there's Bill Hwang of Archegos Capital, who reportedly employed five times leverage to his portfolio of equities and managed to turn $200 million into $20 billion before losing it all in 2021.
Now, whilst I don't expect that you would ever be foolish enough to trade in this way, you'd still be aware of margin requirements on leveraged positions and how these can change during times of crisis. You don't want to be receiving a margin call. Complex portfolios with many assumptions work in the good times, but when volatility picks up, things become unpredictable. So you need to slow down the car.
And you might think this doesn't apply to you, but are you sure? If you have a job, a mortgage on your house, and a stock portfolio, all those three things are tied to the economy. So you are essentially three times levered on the direction of the economy. And it might be even worse if you're an entrepreneur, because you could have loads of stock options in your company that are also completely tied to the economy. But the point here is that whatever the type of investor you are, you need to trade and invest in a way that means you're always able to fight another day and to continue to enjoy and reap the rewards of the market.
Throughout this course, we've been guiding you through the fundamentals of investing, from understanding yourself as an investor, to generating investment ideas based on your views of the market and the economic environment, and your understanding of the different asset classes. However, as we said at the very beginning when we were starting this journey, you might have the best idea and the right time horizon, but execution is where the money is actually made. Most professional investors obsess over execution because they know that a well-executed OK idea and a robust portfolio will drive consistent returns.
In this workshop, we dove deep into all of that. Things like understanding what type of investing you are most comfortable with, finding the right expressions for the ideas, taking only the risks that you want to take. And things like position sizing of an investment, both at initiation and whilst it's live. And then other areas, such as portfolio exposure, and diversification, and a lot more. So to get onto the road to doing this, start by reflecting on all the learning you've done. And begin to brainstorm ideas related to the key points covered in the module.
And if you feel comfortable, I'd love you to share your existing broad portfolio allocation with the RV community, and elaborate on your style of investing and reasoning for holding these positions. And also, if you're having any struggles managing it. Alternatively, you can share a specific investment idea that you've been thinking about. Consider the exact security, the thesis, entry point, and stop loss. Also, time horizon and anything else that's relevant.
Well, that's it for me now. Thank you for your time, and I really hope that you've enjoyed this journey. Thanks very much.