songs my portfolio manager taught me (part 1)

lessons from investment for daily life, rather than vice versa

As the original “manifesto” post said, the prehistory of this substack was a newsletter in which I tried to take some of the principles of decision-making that I’d learned from my day job as a stock analyst, and apply them to the news.  I still think there are useful analogies and heuristics to be drawn from one to another.  Here’s a few:

“When a short position goes wrong, it gets bigger”.

This is an important fact about risk management, and it’s one of the things that makes short selling so dangerous.  If you put 10% of your portfolio into betting against a share when the price is $100, and it halves, then you’ve done well, but now that position is only 5% of your portfolio.  If the price goes against you by the same amount, the share is now $150, you have large losses and your worst position is now about 15% of your portfolio. 

That’s bad; among other things, it means that it’s more difficult for short sellers to hang on and wait for the market to agree with them than people on the long side.  If you’re long and wrong and the share goes to zero, then at least you don’t have to worry about it any more; if you lose 100% on a short position, then not only can you still lose a lot more, but you’ve now proportionately doubled your exposure to that trade.

A very great deal of financial regulation (and a lot of other practices in other sectors) is basically there to cope with the fact that in banking, unlike a lot of other industries, people who are doing business badly will often gain market share rather than losing it. It’s an important thing to know about any system whether there are circumstances in which failures can have this “runaway” property of growing as they get worse.

“no best ideas without a stop loss”

At one brokerage I worked for, we used to create “model portfolios”.  I never quite knew what they were for – surely we didn’t intend them as a service for investment management clients who were too lazy to manage investments? Perhaps they were just an advertisement for our stock picking prowess.  In any case, we had two of them in particular – the “Best Ideas Portfolio” and the “Head of Research Portfolio”.

“Best Ideas” was revised every couple of months, and it was made up of the stocks which had most upside to the analysts’ price targets.  It was just awful, lost money horribly in most conditions and underperformed even in the strongest bull markets.

“Head of Research”, on the other hand, was a fantastic thing.  It outperformed in up and down markets – its performance metrics were so strong that we seriously considered launching a commercial product based on it.

Which is interesting, because the selection method for the “Head of Research Portfolio” was just that it was the Best Ideas portfolio, plus a rule that any position which lost 10% would be immediately cut.

What seemed to be going on was that out of every ten Best Ideas, there would be three or four stars and four or five mediocre performers.  But there would also always be one or two complete dogs, which had huge upside to the target price because they had done so badly, but to which the analyst responsible was totally committed and wouldn’t change the recommendation.

I think about that portfolio often.

“good analysts and bomb throwers”

I mentioned this anecdote in an FT piece last week but for reasons of space it got edited down to make room for more important points.  The guy who said it to me worked for one of the teams that later appeared in The Big Short - he might not need his name dragged into this, but I’ll pass it on if he gets in touch with me to give permission.  He said to me on a phone call …

“Danny, since this crisis began, there have been two kinds of analysts.  There have been guys like yourself – people with decent background knowledge, who have been making a good faith attempt to absorb a huge amount of new information and apply it to get an approximate knowledge of the markets in impossibly difficult circumstances…

“And then there are the bomb throwers.  People whose analytical skills aren’t really all that good, but who like seeing themselves on television and in newspapers, and who have found out that a good way to get publicity for themselves is to mindlessly take part in an arms race of competitive pessimism.

“About a year ago, I decided that it was the second kind of analyst I was going to listen to, not the first.  And consistently, they have been much, much closer to the truth of how things eventually happened”.

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There might be a section here in which I draw out the morals from these fables and explain how I relate them to the wider world, but I have too much respect for my readers to think they need one.