Portfolio Construction and risk management
Let's talk about the formulation of a portfolio and then managing risk.
I’m finally back from traveling and getting caught up on the markets. It unfortunately seems like I missed a lot and it took a bit to catch up but it’s ok because the break from trading or paying attention to markets was a really nice break. I think there’s enough resources out there on QRA and FOMC to figure out we’ll be bullish for the ST so instead of commenting further on that I figured that I will start with an article more geared towards portfolio composition and risk management, basically expanding on the last portfolio update and a previous unheard musing called Risk Management (can read those here and here). I’ve also started a new core portfolio basket I’ve named “China isn’t dead” which will have it’s own substack released in November (hopefully). Now that I’m back from traveling with no further plans anytime soon I plan on really focusing on this substack and releasing a ton of content for you guys. In the future you can look forward to:
China isn’t dead, an overview of the chinese economy and why I’m bullish chinese related equities
Resilient Fossil Fuels, why the energy mix won’t transition to 100% green as fast as some might think/hope, and how I’m taking advantage of this
Steadfast Fiscal Growth, how extreme fiscal spending presents opportunities
Various market commentaries, market research and outlooks in between these 3 ideas.
Each named basket will have an in depth and long piece on each with regular updates whenever they are called for. The other various articles will be shorter of course.
As noted above the china isn’t dead basket and the resilient fossil fuels basket will have it’s own substacks out soon. The uranium basket I have in place kind of already has it’s own substack (see here). I do have some positions in some AI beneficaries, a substack on this basket will take a back seat as I don’t think current market conditions are very supportive of this trend. In the short term I might trade around some names but eventually I will put out something on it. I will continuously provide updates on each basket I write about and tweet out trades so be sure to be on the lookout! The portfolio is still getting organized, but when it’s all in place I will share it.
Portfolio Construction
So let’s talk about portfolio composition. I’m not going to talk about all the different ways to construct a portfolio, many people have already done that in a much better way than I ever could. Some of my favourite books about portfolios and asset selection (courtesy of Capital Flows) are:
Strategic Risk Management
Beyond Diversification
The Allocators Edge
151 Strategies
I’m instead going to talk about how I specifically compose my portfolio in relation to big picture mega trends. I’m a big fan of the book Alchemy of Finance by George Soros1 (maybe a future book review for those who haven’t read it?), so I don’t really care about the reality of how a mega trend spreads, instead I care about the perception and delusions of the market. By doing so, I can navigate the hype cycles of each mega trend which almost always result in bubbles large or small.
Let’s talk about the stages of thematic trading.
The first stage is the emergence of a trend. Trends often emerge from significant events or are highlighted by major beneficiaries (think the aftermath of covid for fossil fuels or NVDA for AI).
The main beneficiaries may trend higher for a period before a major fundamental event makes the market take notice of this trend. This is usually for very specific names in the trend and it’s usually also a good idea to short the laggards before the trend really emerges for the masses.
This stage is the pinnacle of thematic investing. It’s when the trend is at mass exuberance and latecomers start promoting stocks that barely relate to the trend. This is the time to really be selective of both longs and shorts, eventually selling into the peak hype. This stage can last a quarter or two or a few years, timing this is crucial. Despite what people say, there are signs available in order to time these events, Alchemy of Finance goes into this and I will also expand on this in my future book review. Figuring out when a bubble is forming and where is one of the best things in investing that can happen to you.
This is the peak. This is when the market is flooded with companies barely related to the trend at best and will likely never turn a profit. The market’s expectations have entered the realm of fantastical and have almost no basis in reality. This is also when everyone is forced to play the trend, and the way they do are through all terrible companies. It’s the riskiest phase and the time to reduce the long positioning and realize profits on short positions if they’re profitable. Then identify new shorts based on false promises of beta to the theme that have no fundamental justification. This is dangerous to do if you can’t identify the stage of the cycle. Monitor these shorts as reflexivity (Alchemy of Finance topic) will be at it’s peak and consecutive red weeks can work as a signal. Relative strength is also a hugely important signal.
Finally the trend/bubble will pop. This will unfortunately affect all stocks related to the trend, both actual fundamentally viable stocks and the ponzis as the market will now view the trend wrongly as a construct of disillusion. This can be exaggerated by economic downturns, but if the fundamental trend remains intact then this is the time to take the profits from shorts to add to go long again the true beneficiaries at great prices. This is also a good time to implement second order thinking and multi asset diversification in order to take advantage of parallel opportunities in fixed income, currencies or commodities.
How do we determine when the mega trend can actually survive past the original market mania? Easily by asking ourselves a simple question: Does this trend solve a current universal problem or fulfill a need so important and urgent that it can rearrange past market structures? By reducing suffering or increase connection a product or service can become indispensable. Think of products that have reduced suffering: cars and airplanes with longer travels, different pharma products, or certain SAAS services. Increasing connectivity happens with products like cell phones, social media etc. Either way, by reducing suffering or increasing connectivity, products that solve important problems become indispensable and experience a large degree of customer loyalty and rapid adoption, thus making them likely to survive past the market mania.
The overarching goal of identifying mega trends is to operate in a predictive manner, not a reactive one in order to capture the essence of reflexivity theory while being multi dimensional in asset allocations. This comprehensive approach to thematic trading combines macro and micro economic approaches while also incorporating market psychology. Engaging in this strategic approach can capture the upside while limiting the downside and with the ability to efficiently transition between the two.
How do we synthesize all of this into one portfolio? If you’ve been a reader of mine for a while you may have noticed that I used to have a portfolio made up of more random equities holding significant weights, which resulted in serious volatility and a reconsideration of my approach. While some people might not care about volatility, I do. Volatility is avoidable and can impact the ability to compound. We want to be aware of our exposures and the way they interact with events in order to create a smoother equity curve. We do this by outlining an overseeing macro thesis which extends beyond just macroeconomics. An easier way to say this is, identifying what the big picture is, whether that’s a trend in equities, rise in inflation, rates etc. We then express these views with the right instruments. While identifying and viewing the macro landscape we can identify special situations or mispricing’s that we can take advantage. These situations might not necessarily fit any of our mega trend baskets or they might be used tactically to smooth out volatility in our core mega trend baskets. This is where the tactical basket of the portfolio comes into play. Right now the tactical portfolio doesn’t really have much weight as I have been away from the markets. Finally, it’s important to be mindful of the weights of each basket and the specific equities in each basket to understand the exposures of the portfolio (more on this in risk section of this substack).
This approach might sound really complicated but it’s important to keep in mind that we actually want to take a K.I.S.S approach to this. K.I.S.S stands for keep it simple stupid. If a thesis is overly complicated, in all honesty it’s probably not going to catch on and work. Think of the AI run that we had this past year, it was relatively straight forward to understand and implement for the masses. When summarizing an
Risk Management
So now we have the basis for our core portfolio and an idea of how how we will trade tactically, so how do we think about risk? Well first it’s important to understand that we will view it differently from core to tactical allocations. I want to always think about risk in terms of % of NAV, this then allows me to determine what the best position size is by gauging what the downside risk is. A core position basket max risk size would be 3.5-5% of NAV and max 1.5% for the tactical portfolio for myself; this might be different for you. My risk tolerance is not the same as yours, it’s up to you to determine that. This is simply a way to think about risk. So for a basket we need to be conscious of the weights of each name in the basket, the potential downside of each name in the basket and how that ties in to the overall risk/reward of the basket. A basket is usually anywhere from 10-20% of the overall NAV of the portfolio for myself. In tactical portfolio positions this is a much easier process as we just need to determine the potential downside and then size the position in equity terms based on a 1.5% of NAV max risk position. An easy example would be we’ve determined an opportunity with a risk/reward ratio of 3:1 with 15% downside. Based on max position size we would size at a 10% equity position. But let’s keep in mind our overarching goal of a smooth equity curve for our portfolio. At a 10% equity position size in a single name, this can introduce serious volatility, at 15% or 20% it only exponentially increases the volatility. That’s why I also put a cap on max equity equivalent positioning at cost of 10%. We can occasionally allow a position to grow over 10% EQ size to not limit our upside tail risk but eventually it needs to be trimmed. You should also have figured out by now that yes, I do have stops in the core portfolio. I’m not a value investor willing to average down in oblivion. That’s not to say I won’t average down into positions in accordance with max risk as % of NAV in mind, just means that eventually I feel a need to listen to the market, especially given my style of capturing macro trends. I can’t be averaging into losers and letting winners go, I need to capture the trend and resulting mania as best I can.
The whole point of this system is to protect our capital as best we can. This isn’t a perfect system, no risk management techniques can account for elements of uncertainty that are always present in markets. Sometimes we need to go past systematic risk management. Something that George Soros talks about in his book the Alchemy of Finance is being an insecurity analyst and I’m mindful of this. I’m constantly evaluating my book and the trades I have on and although this isn’t a scientific way to manage risk it can still be a good way. The magnitude and frequency of green days and red days can tell us how well we are positioned. It can also tell us how to behave. For instance if we have a period of many green days with very few little red days at a large magnitude, it might not be a very good idea to add to names, in fact we might want to trim some names and take profits. Like everything else, we want to keep everything as simple as we possibly can. If a stock runs up 100% in a few months, take half off. Preserve the initial capital and play with the profits. If it keeps running up you still profit, if it goes down then you can make the decision to either add back to the position or take the gains and run. Simple things like this is a great way to manage risk.
I hope that you find use of reading this. If you want to discuss further you can find me on twitter here. Alternatively, I’m a part of a discord that is completely free. It’s just a collection of traders from all different backgrounds that talk about the markets, so come check it out here! If you haven’t done so, please like and subscribe, it really helps with growth!
I would be a scumbag if I didn’t mention the other people who also influenced this approach. Silver Raven and Doggone on Discord as well as Citrini Research have also heavily influenced this style. Silver Raven and Doggone were always hugely influential on taking a big picture approach to identifying trends that will out perform over time, biggest one they always spoke about since early 2020 was semiconductors, which have performed magnificently well. I’ve always implemented this approach due to them at least a little but on a fast and loose basis. As of the last substack, I’m making a more conscious effort in this approach to be mindful of weightings and being more specific in what assets I hold in regards to big picture thesis’. Citrini also utilizes this approach while also being an extremely effective trader in various asset classes on shorter time frames which I’m in huge admiration of and also wish to implement in my portfolio. Specifically things I’ve taken directly from Citrini in this approach is utilizing long/short positions in each basket and implementing a tactical basket to the overall portfolio. I’m a paid subscriber of Citrini as his work in this approach is fantastic and I highly recommend subscribing.