RAOUL PAL: So portfolio construction, there are some people who look at things as trades. That's OK. But you're not getting the benefits in a macro world of building a more high-quality portfolio.
So we talk about the loveliness of having a trade which is bonds and gold, also dollar and gold because they're inversely correlated. But the dollar has been going up. And the gold's been going up, right? That gives you the ability to take more risk because the movements in the market, if anything goes wrong, one will counteract the other, potentially.
In the very short-term, sure, you get liquidation events and all that kind of noise. But that's noise. But overall, it gives you a more robust portfolio. So I like that.
So let's say I take the banks bet. And the Fed come in and add huge liquidity and more QE. OK, well, I'm long bonds. And I'm on gold.
So I'm going to lose money on my bank bet maybe. But I'm going to make money on the others. That's portfolio construction. And it's super-important.
If you can have noncorrelated bets in that too, now some people use agricultural commodities, yes, they tend not to be macro. I ran, I started and ran a soft commodities hedge fund. It's not a macro trade. I know it. It's not an easy trade.
But maybe you're looking at specific opportunity elsewhere, a noncorrelated bet. And that's great if you can put some of those in your portfolio and you can still monitor them. The other thing is, don't have too many trades because really, the macro right now in this world is mainly risk on, risk off. And you're trying to mitigate that risk on, risk off element and try and build it so it's a bit more robust, that it does what you want over time, that you've got the best expression of those bets.
But some people end up, every idea has a good idea. Are short the banks and, oh, yeah, I want to short Tesla. And we should short oil. And I should show copper.
And I think gold's going up. And I'll buy gold. And before it, you've got a million bets. You can't follow them. Have no portfolio.
What you've just got is somebody who's taken too many bets in their portfolio to express what is relatively a simple view that the economy is going down. And I've made that mistake several times. And almost anybody who runs a portfolio ends up overtrading to start with. You overtrade. You run too many bets because every idea is a good idea.
You need to ask yourself at every point is, should I be doing this trade, why? Because the chart pattern looks good. Well, it's not good enough. That's not a good enough reason.
Because it fits in with my portfolio. Is it the best expression of the view? Have I got this view covered? Well, if it's a better expression of the view than I've got in the portfolio, switch out the other trade and put this one in. Always be improving.
BRENT JOHNSON: The other thing I always say is, whenever we meet, the first two questions should be, number one, where are we making money? And if the answer is nowhere, then that's a problem. That's a big problem.
But the second question should be, where are we losing money. And the answer to that question should be, we're losing money somewhere. And if we're not losing money somewhere, it's not the worst thing in the world obviously. Everybody wants to make money. But it's also a little bit of a problem because if you're not losing money somewhere in your portfolio, then you're not truly diversified.
Now, I know there are some people that say, just put all your eggs in one basket. And watch that basket very closely. And that's fair enough. But there's a higher level of risk associated with that portfolio, I believe, because you just don't know for sure what's going to happen.
And again, my role is not to just make money different to protect it. And so I think diversification has shown that that's the way to be diversified. And the only way to be diversified is to lose money from time to time. And you just kind of have to focus on the big picture and the top line rather than what every little individual line is doing. If you're happy with the top line, you shouldn't really worry too much about what's going on with the individual lines down below.
DAN MCMURTRIE: I want to be liquid enough because the way I think about liquidity is, I think illiquidity is essentially an accident waiting to happen. It will happen. If I have a very defined catalyst, let's say a transactions happening or something like that, I'll take some illiquidity risk. But what matters is what else is in my portfolio.
I will not allow my entire portfolio to be driven by illiquidity. I might have a 5% allocation to illiquid stuff. But illiquidity, leverage, concentration, those are the things that will really kill you.
I'm fine using them. But I'm not going to use them at the same time. And I'm not going to use them uniformly. Those are situational. I have to have a reason to do them.
MAGGIE LAKE: So here you have Dan, Raoul, and Brent all pointing to the same idea, namely, concentration is your enemy when it comes to portfolio construction. And you need to be careful that your positions are not the same trade wearing a different pair of shoes. And frankly, having less positions is likely a good thing at the start. You want to give yourself time to get a feel for your portfolio, read and research, and not spend time just keeping up with the news flow affecting your positions.
And the other way to keep your portfolio from having a drawdown is to think through how to express each of your ideas. You can either look at the risk curve like Cuppy, or look to eliminate market and sector risk through relative value spread positions like the ones Jamie talked about in the discussion.
So when it comes to overall portfolio construction, stay liquid. Or, if you have to be in something illiquid, keep it small. And keep it a simple part of your overall book. Don't get too concentrated as you could suddenly lose money faster than you expected and be a forced seller. Always be mindful of leverage, both in your personal life and your portfolio. And then the final thing is, always be asking yourself, do I need to have this trade on? Does it fit in my portfolio given my investment objectives?
Is there a better expression? And do I have this view already covered? Or going back to what Mark Ritchie said, was this a trade that has now become an investment.
If it has and it's not working, get out. Take the loss and move on. Going into this next clip, we revisit one of our favorite ideas on how to become a great investor, doing nothing. Good traders and investors know what to go for. Great ones know what to avoid.
INTERVIEWER 4: Having no position is actually having a position. And I think a lot of people don't get that because they feel obliged to play in the markets, whereas, that is just not true. If you're playing tennis, for instance, you have to return the ball. If you do not return the ball, of your opponent wins.
INTERVIEWER 5: Right.
INTERVIEWER 4: But in the markets, the market can't shoot at you and shoot and serve and volly and this and that. But you don't have to show up and play. You have the liberty and the option, the very valuable option, to only play when you think you're in good shape. And now is the time to play.
INTERVIEWER 5: Correct, that's correct. But that takes a lot of experience to understand. It takes a lot of discipline to understand. And it takes a lot of antipsychology to understand.
DAN MCMURTRIE: I think one of the things right now is with so many smart people and so much information, I am massively downgrading conviction in my investment process, almost to the point where I don't think it belongs in an investment process. I want to have ideas that I think are good, that make sense on what we think the expected event pathway is, what we think the risk reward is, valuation, all of the stuff you'd expect. But I will not go down on my own sword. I don't do holy wars, none of that stuff anymore.
And if I see something and I think, again, going back to baseline, if we see positions every day where we go, this could be interesting. However, in order to get really good information on this, we're going to have to spend a huge amount of time on it. And there's a very high risk we're going to get borderline obsessed. That's a serious risk, especially for short sellers.
I think everybody online is seeing short sellers get a little obsessed and a little bit crazy. A friend of mine is raising money for a short only fund. And he's had several allocators say, what do you think of the risk that basically all short sellers inevitably go insane? Which I think is a legitimate thing because it's not good for the human brain, again, going back to how your brain processes the world.
It's not good for the human brain to think there is a conspiracy against you. It's really not good if there actually is one because that's really, really bad. And so we're not looking for conviction bets in any of this. We're looking for easy bets.
INTERVIEWER 6: Yeah.
DAN MCMURTRIE: And so my goal is to keep my overall process personally, my firm and my portfolio in a place where I don't need to make these heroic bets. I don't need to make 200% off the bottom last year going all in and risking blowing my fund up. There are funds that have mandates, have that type octane.
That's not what I do because I want to play 50-year game, a 70-year game. I don't really care about one year's return because what's going to matter is the time of compounding more than the individual year. And I will never risk a blowup in my portfolio.
MAGGIE LAKE: Doing nothing is doing something. Don't be afraid to be in cash. And now, you've heard it from the pros. Alex Gurevich himself says, listen, don't overplay your hand as opportunities do come your way, especially if you're more of a cyclical or secular trader.
Jamie talked about this in the discussions that the cheapest and easiest way to short the market is to be in cash. That gives you optionality at times when other people are losing their heads. OK, lastly, let's look at measures to reduce losses in bad times and how to deal with that psychologically, both on an individual position level as well as across the portfolio.
INTERVIEWER 7: But I do want to ask you something you mentioned in your books. And I think it's an interesting distinction you draw between drawdown control and stops. And I think a lot of people conflate the two. Can you tell me why you think they're so different?
SUBJECT 1: Sure, stops were one of the most primitive and are still one of the most popular risk management techniques in trading. You just decide at the beginning, what's the maximum you're going to lose in any bet. And if that happens, you stop it. You might put on the bet again. But it's a new bet.
So I think gold's going to go through the roof when Russia invades Ukraine. And so I buy a ton of gold. But I say, if gold goes down $50 an ounce, I'm going to get out. Then maybe I do. Maybe I lose it, whatever.
If I decide later, no, no, now gold is really going to go through the roof. It's a new trade. And that is a useful way of thinking where each bet is independent. And each bet has a limited loss.
INTERVIEWER 7: So you're tying the fact you've lost money not to just losing money but because you're wrong. It's the fact you're wrong was the important part.
SUBJECT 1: Yes, and the art of setting a stop, you set your stop and you set your position size at the same time. And the art of doing it is, I am going to lose as much money as I'm willing to lose on this trade at the time I've lost faith in it. You never want to be in the situation where, I still believe in the trade but I've lost too much money to keep in.
Or I don't believe in the trade but I've still got unused powder. Then you wasted powder. You wasted capital. So you want to make those two things equal.
Now again, you can't calculate it exactly to the penny. But you want to be thinking in those terms. Most people I risk manage though, are not individual traders trying to pile up a series of bets that win in the long run.
They're are people who are running a strategy. And that strategy might be a momentum strategy, a value strategy. It might be a fund. When you're thinking at that level, you're not thinking about one particular bet. You're thinking of your overall fund.
Their drawdown control makes much more sense than a stop-loss. So if you have a hedge fund for example, the stop-loss is done on an individual position, a bet on gold. The drawdown control is done at the fund level.
And you're saying, OK, if my fund loses 5% in a month, I want to reduce risk. I don't want the fund to lose 10% because if it loses 10%, it can get canceled, and my investors will all redeem or whatever.
So if I lose 5%, I want to cut risk because, partly because my ideas don't seem to be working, partly because I don't want to have a worse outcome. But you're going to put that risk back on someday in the same fund. It's not like you're abandoning the fund. And if you're going to do that, you want to be very careful about how you take down the risk and how you put it back on.
RAOUL PAL: Did you find it hard to put risk back on after having a kind of nasty drawdown? How did you get over that mentally first?
PIERRE ANDURAND: First, we start with like a position that's not very large. And so a way to do it is, if you think there's going to be a big repricing, we could buy some out of the [inaudible]. And I would think, OK, I risk 2% of the [inaudible] over six months. That's something I can afford. That's fine. And then if I want put a little bit of futures but not too, much, and as it goes in my favor and I have more confidence that the rest of the market is picking up on it and then I increase the position as P&L goes gradually. And then the position goes with the P&L.
INTERVIEWER 8: If I'm having a bad day, sometimes I'll take an hour off or just leave early and take the day off, especially if it's slow trading. It's a good idea to do that sometimes because you don't want to overtrade. That's really a bad thing that can happen to any trader.
But in other times, I'm talking about weeks or months even because kind of realizing, OK, what's going on quicker, cutting things quicker, even stopping trading quicker. I've done that a few other times, just, OK, don't do anything. Take a step back. Think about what's working, what's not.
And only do what's working. And only do the best stuff. And that kind of gets you back on track.
And then you have to prove it out. You have to show day by day and month by month that you're winning. And then you can get back to where you were and even go past there in terms of risk taking and risk tolerance and that sort of thing.
MAGGIE LAKE: We've touched on it all the way through. But one important part to risk management is knowing what your exposure is on each investment and across the entire portfolio. And you need to be able to answer that. Similar to what Jamie said in the discussion, most funds look at their portfolio exposure as gross market value for the total exposure, meaning the total value of all their positions, and net market value for the hedged exposure.
When volatility in markets picks up, investors tend to reduce both of these exposures in order to protect their portfolios as the magnitude of each position has increased given the rising volatility. But another sure way of knowing exposure is having stop-losses. You always the most you can lose. And it's that knowledge which is so important during rough periods, which everyone has.
Stan Druckenmiller said, you need to earn the right to start playing big again. Use small bets to reestablish that rhythm and get back on track. That's the tactic that both Pierre and Sager employ when they go through a rough period.
In conclusion, when it comes to portfolio and risk management you need to consider the following. Understand your financial and lifestyle situation. Then decide on goals and match your investing to that. Realize that there are many ways to express an idea so find the right one for your risk tolerance.
Align idea horizon and time horizon. Size appropriately, i.e., leave room to add. And consider adding a stop-loss when initiating.
Before you begin a trade, always ask yourself, why do I need to have this position on? Manage sizing throughout and use it as a lever. Diversify and simplify your portfolio.
Be mindful of leverage and overall exposure of the portfolio. And lastly, don't be afraid not to trade. It's what makes a great investor. Roger will now walk you through all the details.