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Never go all in when investing

Jul 11 2019 10:04
Simon Brown

Bright Khumalo, a portfolio manager at Vestact, recently reminded me of a great Howard Marks quote: “Being too far ahead of your time is indistinguishable from being wrong.” Or, as it typically gets quoted: “Being early is often indistinguishable from being wrong.”

Currently, if we’re buying or holding SA Inc stocks, it frankly feels like we’re wrong. 

But are we maybe just early for the trade? 

I remember that around 2005, a friend of mine was convinced that a giant market crash was coming and that it would be caused by the US housing bubble. 

Ultimately, he was proved right. But by then he had busted out, losing his entire portfolio as he kept on shorting the last few years of a strong bull market.

But how do we know whether we’re wrong, or just early? 

Both can be expensive, or even ruinous. 

Therefore, it is important that we keep checking ourselves, our processes and our positions. 

How do we do that?

The first point is to revisit your thesis.

How did you reach this decision? 

What were the signs you saw and what signs did you expect to see that would confirm your theory? 

I like to use the Bayesian theory, which entails building the model with many different pieces of information and coming to an expected outcome. 

This enables one to revisit each piece of information, check it and also check if you may have missed something. 

The Bayesian theory also accepts that nothing is binary. 

As such, it merely offers a percentage chance of your expectation coming to fruition. 

So, even if that expectation is 80%, there is still a 20% chance you’re wrong.

I’d also hunt for opposing views. It’s not about trying to convince others of your view; it’s just about finding those opposing views and testing whether they have any merit. 

If they do have merit, they could help you identify errors in your thinking.

The other important point is never to go all in – that is to say ‘betting’ all your chips on a single hand. 

Of course, it is great if it works. But it’s a long walk home if it doesn’t. 

Investing is never about going all in. It is about skewing a portfolio to a view. 

So, in the SA Inc example, I certainly do hold a fair chunk of quality SA Inc stocks. 

But I still have my offshore and exchange-traded funds (ETFs) in my portfolio. 

What I then have is a watch list of SA Inc stocks that I will start buying when I start to see further evidence of the SA Inc recovery.

Another important point is to not use derivatives that will provide an exponential return when (if?) you’re right. 

The problem here is that derivatives do not give you the luxury of time. 

They are products that use borrowed money to provide that exponential return, so they cost money every single day you hold that position. 

That means that if you’re early, there is every chance (as happened with my friend) that you’ll run out of money to fund the position long before it starts to show profits.

Then the bigger picture: What if you are wrong? Or if it seems like you’re wrong? Well, the bad news is that, just as we’re never able to be certain that we are right, we equally can’t be certain that we’re wrong. 

Hence, I like the Bayesian approach. 

It gives me percentage odds so I can scale my portfolio accordingly. 

If that percentage is falling markedly, then I should be reducing my positions (or increasing it if it improves markedly). 

Here you’ll note I use the word ‘markedly’. 

A small move isn’t going to change my view, but a chunky 10% move will most definitely see me acting accordingly.

This article originally appeared in the 4 July edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.

investment  |  portfolio  |  portfolio management
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