Sunday, April 21, 2019

The Twin Arrogances in Investing.

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Initially I wanted to just provide a personal update today, but tragedy has befallen my mother's side of the family and, over the next few days I will be hanging out with my my dad while my mum goes to Johor to pay her last respects to her youngest brother.

The other thing is that Kyith of Investment Moats wrote a really objective article on leverage that you can find here. I strongly recommend that you read it to get under the hood of how most leverage strategies work. I this the article is sufficiently well-written such that a public rebuttal is unnecessary, any specifics on why my method works is something I can only discuss with my students behind a pay wall. Given how polarising leveraged investing is, I do appreciate that it must be damn hard to write a balanced article like what Kyith has done.

Nevertheless, I just want to add to the discussion something about the Twin Arrogances in Investing.

a) The Arrogance of Superior Asset Allocation

The first arrogance of an investor is that belief that he is a superior at allocating assets. If you think that markets are bullish, you tilt a portfolio towards more equities and less bonds. If market are indeed bullish, you will outperform someone who has a larger allocation in bonds. If markets are bearish, you will underperform.

Promoting leverage falls into this category of arrogance and hubris. When you have a normal portfolio, you may be 70:30 in equity:bonds. When you are leveraged we typically go 120:-20 or even as extreme as 200:-100.

Interestingly the "girly men" who stick to a warchest also fall into this category. They may go 50:0 because the right hand side is largely stuck in cash. So if their superior portfolio returns 20%, they only generate 10% over their entire portfolio. A lot of folks only count the returns of their equity portfolio and fail to account for their cash drag which next to zilch while waiting for their next big bet.

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b) The Arrogance of Superior Security Selection.

The second arrogance is superior security selection. It is this idea that by spending more time to assess a stock, you will be able to pick a portfolio that provides superior performance. When we do quantitative backtesting, we also have to be careful of this belief that models will retain its usefulness over time.

If we all have infinite time to investigate every stock, then it may be better to go after superior security selection. The problem is that as we put in more time, we also get diminishing returns. Worse, time spent becomes a sunk cost and many value investors get fixated on specific stock counters. I have witnessed so many investors get trapped into just looking at a few stocks and for years, these counters never go anywhere close to their intrinsic value.

Let me share an "almost embarrassing" example made by me and my own students.

In the last class, my students were sent to investigate Cache Logistic Trust. After a review on analysts reports, they concluded that Cache should be thrown out, citing declining cash flows as the reason. Cache was 75 cts at that time. I was uncomfortable about Cache being 75cts as well so I was too pleased with their findings to argue with them.

Immediately after I built my portfolio with training fees, the CWT default occured and Cache crashed to 71.5cts, then all the online armchair theorists starting screaming about Cache's exposure to CWT which was estimated at 20%-30% at that time. So the 3-6 pairs of eyeballs went to read reports written by paid professionals (often CFAs) did not even clearly flag the CWT default risk even once. One report in January even cited CWT lease expiring as a risk.

It did not stop at my students. The armchair theorists also missed out the real exposure to CWT which was reduced to 16% after a clarification from the REIT that evening.

I think as retail investors we overestimate our ability to do the the deep investigation that even professionals struggle to do.  I'd fully admit that even with 30-50 brains in every class, a collection of analyst reports written by an Army of CFAs, my class makes a lot of mistakes rejecting stocks from the portfolio (which I record them all to teach future classes). We still do it in principle because one batch of students rejected all 3 stocks correctly (possibly by luck) and made 40+% returns in about 4 months.

The question of Asset Allocation and Stock Selection is, of course, an aged old debate that CFA candidates study. At least over a decade ago, the verdict is that asset allocation matters more in portfolio performance than stock selection.

I think on balance, we still need to guard against the hubris of thinking that we are fantastic asset allocators. I have always maintained that leverage is something Millenials and Gen Z HAVE TO DO because they face such short career trajectories before they have enter the cycle of retaining and retrenchment that will cripple their lives in their 30s and 40s. If someone wants to critique my methodology, you should provide a template to give a young 20-something a career that lasts at least 15 years which was about how long I took to retire WITHOUT LEVERAGE.

Actually, I'd rather my students avoid taking the risk of a margin call but I bet even the PAP government does not have a solution.

No government in the world has one right now.

Anyway, my student are sitting on fairly massive gains so far, so they should be reminded that a lot of superior performance comes from leverage and this will soon reverse itself if REIT markets go south.





  1. Hi Chris,

    I think that it's better to be humble with the approach. Diversification is the way to create the buffer in the case of stock failing. If one basket of investment fail, there are other baskets of investment to make up the losses or at least reduce the losses.


  2. Definitely, I also don't want my students to get ahead of themselves. August can be a bad month.

  3. I think it's still Spring for leveraged investors. LOL!

    It's not the 1 or 3 months of downturn that will cause real damage. Heck even the average -15% correction takes 6 months to play out. This recent recovery is abnormally fast, very much like the recovery in 2009.

    I suspect many leveraged portfolios will blow up in the next yearlong bear market especially if they form 2/3 or more of their total investments.

  4. Unknown,

    I will keep what you say about a year long bear in mind.