Thursday, August 13, 2009 2 comments ++[ CLICK TO COMMENT ]++

Newbie Thoughts: Characteristics of my newbie (concentrated) portfolio [VERY LONG]

When it comes to investing or personal finance, things generally get more complicated as your become more experienced. Taxes start out easy but they get more complicated as the number of securities increase or as you move away from simple common stocks to other types of securities; initially you may only invest in your local market but if you ever invest overseas, things can be complicated; and so on.

However, there is one thing that I believe is more complicated early on. My opinion is that measuring your portfolio performance and determining the efficiency of your portfolio is tougher early on (by efficiency, I am referring to whether you trade too much, or whether you hold too much cash, and so on.) The reason for the difficulty is something that actually benefits the investor.

Based on my experience, the difficulty early on arises from the fact that savings will be high relative to the total portfolio. For instance, if you start with $5000 and add $1000 every few months (or whatever), the amount you add is very large relative to your portfolio. In essence, you are dollar-cost-averaging and newbies get a huge bonus from this—cherish the automatic dollar-cost-averaging you get early on in life since you will have a hard time impacting your portfolio later on in life (when your portfolio is large.) The only time dollar-cost-averaging hurts is if you are doing it near a market peak and prices keep falling for a long time. In practice, countries that grow have upward sloping stock prices so dollar-cost-averaging almost always helps. (This dollar-cost-averaging issue is very important and I'll write about it in the future.)

Measure Your Net Worth

I think everyone should measure their net worth. You can simply track it every few months or whatever suits you. I use Microsoft Money, a personal finance software, to track all my finances so net worth is easy for me track (use Quicken or whatever else you feel suits you.) Net worth is also easy for me because it's very small for me and I don't have any major assets (I have my entire net worth invested in the stock market, although it may be in cash at times.)

In the grand scheme of things, net worth is what matters in the end. It is also important to look at that because it captures asset allocation decisions that you may not have thought about. For instance, someone that may have purchased their home or are paying down the mortgage is actually making a quasi-investment decision. Strictly speaking it may not be a pure investment (unless you are into real estate and know your stuff) but one does tie up a lot of capital in their homes. Conversely, someone that has nearly all their wealth in stocks and bonds while paying rent is implicitly allocating their capital to financial assets at the expense of a house.

Depending on how your measure your investment returns, looking at net worth may also point to inefficiencies. For instance, idle cash may be captured when looking at the performance of your net worth, whereas it can be easily forgotten if you just look at your portfolio returns.

Anyway, even if you don't measure net worth per se, make sure your portfolio measurement properly accounts for cash you are adding to your portfolio, as well as cash that is sitting around.

Should Benchmark Against Bonds Too

Everyone benchmarks their portfolio against stock benchmarks but one should also benchmark against bonds. Even though one owning any amount of stock will likely beat bonds in the long run, that may not be the case in the short to medium term. Also, if we enter a severe bear market, it doesn't help if you are beating stocks but you would have been better off owning bonds (classic example of this is Japan in the 90's: Japan had a huge bull market in bonds in the 90's but stocks were a complete disaster. Even if you beat the Japanese stock market, you may have ended up destroying your net worth.)

Passive investors have an easy time beause they can simply benchmark against their asset allocation. For example, if your portfolio is 70% stocks and 30% bonds, you should benchmark against an index that is 70% stocks and 30% bonds.

In contrast, picking a proper benchmark is tough for stockpickers. People like me are willing to invest in any asset class so there isn't a proper benchmark.

I don't benchmark against a bond index per se but do consider a hypothetical benchmark that earns 5% per year as representing bonds. In the long run, bonds earn roughly 5% in nominal terms. For example, even in the ultra-low, deflation-fearing, interest rate environment of today, 10 year US Treasuries are yielding around 3.9%. Over the next 30 years, a rough guess would be for the average yield to be 5%.

Actual Portfolio Returns

As crazy as this may seem, my actual portfolio return is quite different from the returns I have posted on the portfolio returns page. All the returns I report are true but if you took my annual returns over the years and computed the cumulative return, it will be quite different from what actually happened in the portfolio. The reason is because I keep adding to my portfolio (i.e. I have positive savings) so I am implicitly dollar-cost-averaging.

What I am saying applies to everyone out there. Nearly all the historical returns that you may run across, either on other blogs, or fund documents, or academic studies, generally assume a fixed portfolio. Young people or those with small portfolios continuously adding to it will see different results.

My Portfolio Return

In the chart below I have plotted my net worth, along with a few benchmarks. The line marked 'Savings Only' is an estimate of my net worth if I save a constant amount every month under the mattress. The blue line would be the case if I had saved a constant amount every month and earned 5% per year (this would be an approximation of someone who puts all their savings into government bonds*.) The 10% line is roughly what you would earn in the stock market in the very long run. I also plotted my main benchmark, Dow Jones Global Total Market index, which is a global stock market index. I have adjusted the Dow Jones index for currency fluctuations (I'm Canadian and measure everything in C$.)

The chart should simply be tought of as a rough guide and not as something precise. It's something for you to think, perhaps about how your portfolio may behave over time. There are some assumptions that sort of distort the chart a bit. For instance, all the lines, except net worth, assume that I am saving a constant amount every month. This is why the savings line is a upward-sloping at rising at a constant rate. The net worth line, in contrast, is my actual portfolio and my savings are not constant. I might add some money one month and not add any more for 6 months. So the net worth line actually understates my performance slightly. In the grand scheme of things, this shouldn't matter because I add roughly the same amount to my portfolio every year. There are also some other discrepancies such as the fact that my net worth line includes witholding taxes and commissions while the other lines don't.

The 5% line and the 10% lines are exponentially growing while the savings line is a straight line that grows at the rate of your savings. It's hard to tell from this chart because it spans only a few years but over your lifetime, the differences grow exponentially and will be materially different.

I have been investing for roughly 5 years so this chart gives a good idea of a newbie with a concentrated portfolio. My performance is also quite poor so it also gives an idea of what happens when you aren't such a good investor :(


Poor Returns So Far

I have earned around 3% per year, which obviously isn't very good. I have underperformed the hypothetical bonds (5% per year) and am nowhere near the 10% line either.

I even lost money for a while there. I suspect many newbies, and even veterns, will have some concerns if the portfolio goes negative. I don't care much about money (really ;) ) and my portfolio isn't that large so this isn't an issue for me. But most of you reading this needs to keep a strong mind if you go negative. It either means that you are a very poor investor and shouldn't be stockpicking; or it means the market has crashed and you are looking at valuations near a trough. Whatever it is, don't give up, unless you conclude that you are not cut out for investing.

The collapse in my returns, below the savings line, is not due to the market crash! My returns are not correlated much with the market for several reasons. I invest in contrarian situations, in out of favour industries or distressed companies, and these stocks live in their own world; I have made it my goal to invest a sizeable chunk in special situations (risk arbitrage and liquidation so far) and these are not correlated with the market at all; lastly, I also had a short position against the market in the last year or two, so my portfolio was more market neutral. So my negative return is purely my own fault and is very dissapointing. It is largely due to a stock that starts with the first letter of the alphabet ;)

Concentrated Portfolio

Because I'm a concentrated investor, most of my gains and losses come from a few positions. These are highlighted on the chart with the green and red boxes (green is a gain and red is a loss.) Initially I wasn't as concentrated but in the last few years I have been.

You will meet a fork on the investment road, if you already haven't, and one direction will point to 'concentrated portfolio' and another will point to 'diversified portfolio.' Your decision is extremely important and will have a major impact on your returns and the strategies you follow. I chose the first one and I'll write about why in the future. I don't think there is a right answer. Even sticking within the value investing school, Benjamin Graham and Walter Schloss favour a diversified portfolio while Warren Buffett and Edward Lampert favour a concentrated portfolio; in macro investing, George Soros seems to favour a diversified portfolio (I'm not entirely sure about this because Soros does make huge, specific, bets) while Jim Rogers seems to favour concentrated investments in particular securities and industries.

The Power of Dollar-Cost-Averaging

If you are a newbie and not familiar with it yet, do spend some time reading up on dollar-cost-averaging. Even if you don't explicitly follow the tactics—it's generally suggested for passive investors—you can sort of tailor your portfolio to take advantage of it. It is very benefitial during bear markets or when valuations are low.

People who are in the early stages of investing, like me, will get an automatic benefit from dollar-cost-averaging. This is because, for most people, the amount they save per month or every 6 months or whatever, is large relative to their portfolio. I don't set out to save an equal amount every few months but, in practice, I end up saving periodically.

The periodic savings actually impacts the portfolio for younger people or those with small portfolios. Later on in life, or when your portfolio is large, the amount you save will have little impact on your return. (Later on in life, you have to be careful with capital losses whereas it isn't that damaging when you start out.)

You can get a sense of the power of dollar-cost-averaging by noticing that my portfolio is currently above the peak set in December 2007! Recall that this is with a massive crash in the last two years; or in my case, a horrible investment in Ambac (more on this later.) Some of the recovery is due to good investments and the decline in the Canadian dollar (my holdings are mostly US$) but most of it is actually because of the additional savings since the 2007 peak. If I didn't add savings, I would probably still be below the "savings only" line.

You'll notice that the Dow Jones index has also surpassed the peak set somewhere near May of 2008. The recovery beyond the peak is mainly due to additional savings that were invested in the last year (the strengthening US$ also helped.) In contrast, if you look at the raw index, it is still down around 30%. Now, the Dow Jones index is still below the "savings only" line. That is, someone who was in cash from day 1 is still outperforming the index. But, nevertheless, continusouly adding to your portfolio has narrowed the gap beween cash and the index (if you didn't DCA, the gap would probably be twice as big.)

To put it another way, dollar-cost-averaging, assuming the market is not wildly overvalued, will lower your cost base (if bear market) or keep the cost base low (if slowly rising market.)

My So-Called Investing Life

Early on I was primarily into what I call sector rotation. This is macro strategy that attempts to invest in sectors that are in favour. Early on, I was bullish on commodities, but not bullish enough to bet big :(. Later on, I became more of a value investor when I turned bearish on commodities and couldn't find anything else to invest in (it also seemed that value investing was a bit more rational :)).

Although I was always more concentrated than many, I became a full-fledged concentrated investor later on. I'm telling you all this because anyone pursuing concentrated investing should observe what happens when you make a mistake.

I made a concentrated bet on some bond insurer called Ambac in early 2008. This was the biggest investment of my life and was around 25% of my portfolio. This was also when my portfolio was at a peak and, hence, the investment was also the largest in dollar terms. Cutting out all the exciting backstory ;), Ambac ended up being a terrible investment and I will likely take a 100% loss.

If you are a concentrated investor, it is important that you realize that mistakes will be more costly as a portfolio grows. This is true for anyone but especially so for concentrated investors. To give you an idea, my Ambac investment wiped out all the gains from the prior 3 years! Roughly 10% per year for 3 years instantly vaporized with one investment. So, you need to be cognizant of the potential portfolio impact.

Some professionals scale down their concentration as their portfolio grows. For instance, they might invest up to 20% or 25% when their portfolio is small, but only invest 5% to 10% when their portfolio is large. My portfolio isn't very large but it is sizeable given my somewhat low-paying job. I decided not to reduce the concentration because I couldn't find anything attractive and it's harder to follow too many companies. If you are a concentrated investor, you need to decide if you should be scaling back the bets as the portfolio grows.

The other thing I want to mention for concentrated investors is that, if you take a large position, it may be difficult to add to the position because it's already a big position. This is not visible on the chart but it is the case with my only core holding these days, Montpelier Re (MRH). I didn't make up my mind—I was dissatisfied with management's oversight of the insurance portfolio—but I was thinking over the last 6 months whether I should add to my MRH holding. I think it was around 25% of my portfolio near the trough (mostly because losses in others made this a bigger share) and it was just very difficult for me to add to it. A value investor living in an Ivory Tower would say that one should add if the stock was undervalued but I have low confidence and ending up with a huge position in one stock is a bit too scary for me regardless of how cheap it appears.

I should note that the amount your invest also depends on your investment strategy. For instance, I am pretty comfortable investing, say, 40% in one stock if it were a liquidation play (haven't done that yet though.) But I would be scared to invest 40% in straight common stock investing. Mainly this is because I'm not a good stockpicker but it's also because the instrinsic value is more certain for liquidations. You can always be off with your liquidation estimate, and let's forget the potential for fraud, but it appears far less risky than plain common stock investing.

Some investors "ease into" positions. Even if they wanted to invest 20% in a company, they might start off by investing 5%, then 10%, and then another 5%, or whatever combination is reasonable given commission costs. I have thought about it but I don't pursue that right now. The problem I have is that this seems to involve some notion of timing. After you invest 5%, how do you know when to invest 10% more? It's easy to say 'when stock price falls' but what if doesn't? Are you betting on the price falling? What if you did a lot of research and feel this is a good opportunity? What if you just invest 5% and it gets away from you?

I don't think there is a right tactic for small investors. You need to decide if you want to "ease into" positions or not. Some people use formulas like the Kelly Formula—Mohnish Pabri once suggested it but I don't think he ever uses it—but I think it's useless**.

The Future

In my case, I think my savings rate will decline as I age. I will attempt to always have positive savings but the amount will likely decline. Who knows what will actually happen but this may be because I have kids (additional costs), I buy a car or a home (can be costly), I go on more vacations, and so on. I don't think my work income will rise, especially since I am forecasting mild-deflation/low-inflation, so it is likely that the savings rate will decline.

For many in my age group, say late 20's to early 30's, the situation will be opposite. Most of my peers have had low savings rate (negative net worth in some cases i.e. debt) and will raise their savings rate over the years.

If you are much older or have a large portfolio, it is likely that your savings will be largely irrelevant to your portfolio. The amount you add will not move the needle and you won't get much of a DCA (dollar cost average) benefit.

So the behaviour of your portfolio will depend on where you fall. If your portfolio is large, or your additional savings will decline (like me), capital losses will be very damaging. So one may want to factor that into their investments.

Ideally, you should save as much as you can when you are young. In practice, this is difficult because most people want to enjoy life when they are young. Whatever it is, when you are young, try to save as much as you can, without jeopardizing the lifestyle you want to lead. Due to compounding, early savings are far more benefitial than later on. I'll write about this later but the difference is truly staggering.


* Very roughly speaking, in the long run, bonds have an annual nominal return of around 5%. Stocks return around 10%; real estate around 7% to 8%; money-market funds and gold 1% to 3%; I don't know what the verdict is on commodities. To get the after-tax, real return from these numbers, you should subtract around 3% for inflation, around 1% for transaction cost and 1% for taxes. These numbers are good rule of thumb for most developed markets, such as USA and Canada. If you mostly invest in emerging markets, undeveloped markets or frontier markets, the numbers will be different. You will tend to have much higher nominal returns, while also having much higher inflation and higher transaction costs.

** The Kelly Formula reminds of the DCF formula, which is another formula I'm not a fan of. The Kelly Formula is intellectually attractive but almost useless for investing (note: I'm only talking about stockpicking; I can see such a formula being useful for quantitative investing or some sort of program trading.) Similar to the DCF, the Kelly Formula requires you to estimate variables and you can literally end up with almost anything. In particular, investors are likely to over-estimate the chance of success. After all, if you have already decided an investment is really good and worth risking your precious money, you are likely biased towards the positive. I know I am. (I'm also not sure if there are assumptions, especially about the probability distribution, that may not be applicable to investing. I haven't looked at the proof. If it assumes normal distribution, take some advice from Nassim Taleb and run away :) )


2 Response to Newbie Thoughts: Characteristics of my newbie (concentrated) portfolio [VERY LONG]

August 14, 2009 at 4:53 PM

Great article...Very informative...Its always amazing how even a little saved early makes a big difference later on thanks to compunding...

Jae Jun
August 15, 2009 at 4:30 AM

Wow made it to the end. Good job though.

I used to try and benchmark against other markets but I found it to be a waste of time as I just kept comparing numbers rather than use that time for other stuff.

In the end what matters is that I don't lose money. As long as I either keep up with inflation or beat it and don't lose anything in the process, it's a victory for me. My only other requirement is that I beat the market otherwise I'm better off with an index.

Regarding portfolio concentration, I'm discovering something else these days. I too have a small portfolio but it has doubled this year which is quite quick even by my standards. However, before when a $2000 position took up 15%, I now need to allocate $4000 for the same percentage, but I forget and have been ending up buying lots of smaller positions.

Of course its a good dilemma to have but I'll have to concentrate more on capital allocation.

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