Process for Choosing the Securities in a Portfolio
I've been interested in the process by which a portfolio is created lately, not in terms of how managers decide on individual investments, but on how they construct the portfolio as a whole.
Is it simply a process of choosing the best investments that fit into the fund's investment style, and appetite for risk (i.e. do they make investment decisions that do not take into account the other investments in their portfolio beyond the risk of the entire portfolio) or do they have different expectations for each investment, such as different industries, reactions to certain changes in the economy, etc?
Not that I have great experience, but I'm head of one of the largest student-run equity funds in the US. Our benchmark is the S&P 500, so the first thing I look at (after an initial run through with the analyst and his/her sector head) is our allocations vs. the S&P 500. We're bottom-up focused, and don't want our performance to be dictated by sector allocation discrepancies vs. our benchmark so we stay +/-5% over/under weight regarding sectors. After that we'll analyze the risk of the investment (perceived risk/reward & beta) and in most cases it just comes down to if the company looks under/misvalued compared to its peers/cash-flows. Again this was an extremely brief explanation, and our process is trivial compared to any professional money manager.
Many aspects to portfolio management, but let me touch one one: diversification. I like to express my view in terms of an analogy...
Let's say you have 100 dollars to your name. The only way to earn more is by playing one of the following games:
Which of the following games are you most likely to play? Assume that you are able to play either game as many times as you'd like, with a wait time between sessions of 10 minutes. You can't switch games.
1) Bet is $100, flip a coin: heads = x6 your money; tails = x0 your money 2) Bet is $10, flip a coin: heads = x4 your money; tails = x0 your money 3) Bet $0.50, flip a coin: heads = x5 your money; tails = x0 your money
Although game one has a higher expected payoff, if you lose the first round, you're unable to play either game going forward.
Alternatively, game three has the second highest payoff, but the small bet would make it so that it takes way to long to compound your money.
This leaves us with game two, which given the circumstances, and IMO, is the best game to play if you are looking to maximize your wealth.
One can use this analogy as ONE way of looking at portfolio management. Lack of diversification may give you the highest expected returns (game one), but Lady Luck may kick you out of the game before you can capitalize on it. Alternatively, just because you have found an investment that is diversified and offers a good expected return, you can't put enough money in it to be worthwhile (game three) - the position is insignificant.
It should be the portfolio managers responsibility to find game two. This would mean incorporating, say, the fund's best 40 ideas, rather than the best 10 or best 100. It is an art in the sense that you want your best ideas to have significance and a large position size, but also realizing that even your best ideas have a chance of being wrong.
Screw diversification. Read "The Little Book that Beats the market" and follow their method.
You're right. I'm going to sell my entire portfolio and buy AAPL.
You're an idiot if you think you're 'diversifying away risk'
"we get protection by being price-conscious and by being extremely knowledgeable about our holdings. And diversification is a surrogate—and a damn poor surrogate—for knowledge, elements of control [of a company] and price-consciousness."
Boom your whole lady luck and diversification - blown up in one sentence.
I said to diversify to acknowledge the probability that your highest conviction ideas are wrong, not to simply "diversify away risk", which can mean anything. This thought process is in-line with portfolios that may have 20-60 holdings.
And I agree with the fact that diversification is a surrogate for knowledge. If you knew with extreme certainty what will happen to the market or your investments tomorrow, then you should just be holding one security - the one with the highest return. Some diversification (read: 20-60, hard to put an exact number on it...by no means the S&P 500 or R3000), to me, a signal that an investor understands that they can just be flat-out wrong on their thesis. Higher conviction = higher weighting...but until there is ~ a 100% chance your thesis is right, then you should have your second, third, fourth, etc., best ideas in the portfolio also.
Thanks for posting that quote - it even further supports my argument. That's why the more informed investors typically have more concentrated portfolios, while the least informed (should) have extremely diversified portfolios.
Quoting Marty Whitman I see? He is the man.
'Safe and Cheap' guys acknowledge downside investment risk and attempt to mitigate it by acquiring the position at a substantial discount to the underlying value of the company. Sometimes you'll have losers though, you just won't 'lose' as bad as others b/c of this 'margin of safety' (Graham/Dodd term).
You don't put all your money in one position, obviously. A lot of fundamental l/s equity guys have like 70-80% of their capital invested in their top 10 positions. If one position happens to be a once-in-a-decade Enron type scandal, you probably screwed up somewhere in your analysis, but it's not going to wipe you out.
Going further, if you were in the Buffett-type, high margin of safety investing, stocks like Enron probably wouldn't even have fit in your category. If you hold a basket of high quality businesses that you bought for cheap, chances are your downside risk is pretty solid.
So the only reason that portfolios have multiple securities is for the sake of diversification/mitigating risk? From what everyone has said it seems that PMs make individual investments as stand alone investments, not considering the entirety of their portfolio beyond risk/beta.
Right, so, correct me if I am wrong here, but the message I am getting is that there is a benefit to "diversification" at the lower bound, so to speak? By that I mean we all agree that having all your capital invested in a single trade is a bad idea, no matter how "value" your approach might be. Using 70-80% of your capital on 10 trades, on the other hand, is better, for the reasons mentioned. I would naively call this diversification of sort, but I understand that the degree to which value investors apply this is very limited, for all the obvious reasons. I would also note that I don't know of a single professional investor who doesn't practice some degree of diversification, one way or another (even if that 'diversification' is defined as having a portion of the portfolio in unencumbered cash). I guess this is a point that another poster above had mentioned already.
Thank you for the book recommendation and the discussion.
Even 10 positions in a somewhat equal distribution is considered diversification. In fact, after 8 or so positions, the benefits from diversification erode, and it is better for managers to have 8 high conviction ideas rather than 100 low conviction ones. At the same time, Dubya is right in saying that you obviously can't be 100% sure of your bets, which is why you need to have multiple. To take an extreme example, look at Bill Ackman: at the end of 2012, he had billions of dollars in 9 positions (not including shorts). His top two positions were 46% of his portfolio.
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