Portfolio Principles

Portfolio Principles – Risk Management

Risk management is arguably more important than any actual trading strategy. Multiple traders can run the same strategy, but could get widely different results because of their risk management rules and whether or not they actually apply their rules properly under market stress.

Take risky positions with small amounts of capital that limit downside on trade entry

Use capital efficiently – for example use ETF option spreads or deep ITM ETF call options instead of buying ETFs outright.
Where possible with exchange listed products use option spreads on trade entry to limit downside risk.

For risky positions in small cap or alternative investments the stop loss is zero, so only enter with what can afford to lose (e.g. use maximum $10k per idea).
Visualise what to do if that $10k position is down 90% – should be nothing because the risk was sized on trade entry.

Risk is always sized on trade entry and never increased through the lifetime of the trade

Don’t reestablish the same trade immediately after exiting for a loss. That is effectively the same not having any stop loss risk management.

Everyone has their maximum risk limit tolerance, except for some very rare investors like some institutional traders who don’t feel emotion or pain on losses.

Investment Themes

Cash is a really bad long term investment, and should be thought of as a constantly decreasing asset due to inflation. However cash is very useful to have for short or medium term opportunity. 100% invested is likely missed opportunity cost for an investment theme not thought of yet. 100% invested all the time is only suggested by the fee based investment management so they can get paid.

Recognise the difference between “themed generation investments” and just a trade. Long SPY call spread $250/$255 for next month, is just a trade (so don’t leave one leg on and treat it like an investment). Long bitcoin or 3D printing stocks can be a multi year trade.

Trading and long term holding are both ok in a portfolio – just be clear which positions fit each category.

In volatile markets like crypto currency a month can feel like a year. Global stock markets are not truly as volatile because they are very mature market – the perceived volatility is often due to investors position sizing traditionally makes it a large part of their net worth.

Don’t attempt to follow investment theme advice from too many sources because it clouds your vision. but read as much as you can on different investment opinions and perspective. If you read something you don’t agree with – decide why you don’t agree with it and see if there is any thing it could add to your own rules. Always stay with your own rules. Importantly investment is about what you believe other market participants will do, not your personal opinion. Your personal opinion on market direction isn’t worth that much. e.g. if you think S & P 500 is on the biggest bubble since Dutch tulips, but you have noticed that many other people are comfortable with it – might be getting limited long exposure.

House Money

“A stock operator has to fight a lot of expensive enemies within himself.” Reminiscences of a Stock Operator by Edwin Lefèvre

After a large profit take the original risk out of the position, then let the rest run as “house money”. Always try and play long term with “house money” if you can because it removes some of the original fear of loss from the trade.

You are probably limited by what you believe is a lot of money. This type of scenario is directly applicable to the crypto market for the last year. Assume you invested $10k, then exited original $10k from position – so still have a position but no risk – and over time the “house money” position goes to $100k. If ultimately lose $100k of “house money” from the peak valuation of that investment – is that an acceptable risk ? If you make have unrealised gains of $100k do you want to exit immeadiately because you cant stand to give it back ? What if the unrealised $100k profit goes to $50k but they goes to $200k afterwards ? Can you handle the swings – even with house money ?

Do you assess the trade based on how much money you have in it ? Or it is based on the investment idea still being valid ?

If you lose on the trade do you anchor to that loss ? Or do you believe that opportunity always come along ?

There are never optimal trades in financial markets, only “good enough”. You will always leave something on the table. Does this achieve initial trade targets ? Whether is was a winner or a loser – was it a well managed trade ? Loser management is as important as winners.

The legendary investor Bernard Baruch who came through the 1929 crash mostly in tact was asked what made him such a successful investor. He replied: “I always buy ‘too late,’ and sell ‘too early.’”

Managing position trades through big swings

“It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight! It is no trick at all to be right on the market. You always find lots of early bulls in bull markets and early bears in bear markets. I’ve known many men who were right at exactly the right time, and began buying or selling stocks when prices were at the very level which should show the greatest profit. And their experience invariably matched mine–that is, they made no real money out of it. Men who can both be right and sit tight are uncommon.” Reminiscences of a Stock Operator by Edwin Lefèvre

“Old man Partridge’s insistence on the vital importance of being continuously bullish in a bull market doubtless made my mind dwell on the need above all other things of determining the kind of market a man is trading in. I began to realize that the big money must necessarily be in the big swing. Whatever might seem to give a big swing, initial impulse, the fact is that its continuance is not the result of manipulation by pools or artifice by financiers, but depends upon basic conditions. And no matter who opposes it, the swing must inevitably run as far and as fast and as long as the impelling forces determine.” Reminiscences of a Stock Operator by Edwin Lefèvre

“Bill Gates got his money because he owned a stock, Microsoft, and it went up eight hundred times, and he stayed with the trend. He sat through one of the greatest bull runs in the history of civilization. He understood the pain of gain.
Paul Tudor Jones (Tudor Investment Corporation) in Tony Robbins “Money: Master the Game”

Personally I believe it is physiologically easier for me to trade a limited risk option spread strategy because I know how much I can lose every month – but the expected return is only 5% to 10% a year. However handling huge swings in a wild crypto bull market is much harder – yet infinitely more profitable – and after taking out the original stake to play with house money there is no money at risk. It is way more profitable to simply hold positions in a bull market, than trade around them.

Position Entry

This quote is from Paul Tudor Jones (Tudor Investment Corporation) in Tony Robbins “Money: Master the Game” – after showing a picture of rapidly sloping up chart with a “You are here” arrow at the top of it, this is the quote:

“How many people want to be long and stay long this chart?” And about 60% will raise their hands. And how many want to get off this investment and sell it ? Then 40% or so will say get out. And I say “You 40% should never ever invest your own money in your entire life! Because you’ve got this contrarian bug, and this the greatest way to ruin that there possibly is. It means you’re going to buy every brand – you’re going to buy things that go to zero and sell things that go to infinity.”

Do you have a temptation to buy cheap on the way down? Buying cheaper is good, but better done when potential is not yet released in new issues that have no overhead supply. Will make more money buying into a market rising off a low base, than trying to pick a bottom in a “race to the bottom”in multi month decline.

Which of these are you tempted to buy ?

Option 1 – uptrending market that is already 20% for the year moving to recent multi year highs, off a 1 year flat base
Option 2 – downtrending market that is already down 60%, and heading steadily lower over a number of months with some -10% months along the way

Its really hard for me to do 1 & very easy for me to 2, because of personality type. Don’t like to overpay for anything & like the idea of getting a “bargain” (cheapskate). Plus the implication that you are smarter than the market because you picked close to the bottom (ego).

Final quote from Paul Tudor Jones “Don’t be a hero. Don’t have an ego. Always question yourself and your ability. Don’t ever feel that you are very good. The second you do, you are dead.”

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