Risk Management.

Risk management.
May 20, 2014 11:20 am | manishdhawan@live.com
Risk Management

This article is going to hurt the conventional Value Investors and technical analysts alike. If it does that, I will pat my back for job well done.

Invariably, almost all the people I have spoken with (barring few rare exceptions) suffer from a serious commitment and consistency BIAS for their chosen stream of profession. The love of their way of thinking is so BIG, that they discard and disrespect and even despise the others point of view.

I am sure this holds true for any profession but in my industry Value Guys think they are sitting on some idealistic porch from where they have the right to judge the world and technical fellas believe they are so pragmatic and in the now that lines/charts talk to them.

I apply multi-disciplinary mental model in my thinking and I am from the Meb Faber school of thought. Think about it, why should I handicap myself by thinking from 1 perspective only when I can use both.

Both the systems have inherent flaws in them. The commitment bias does not allow the protagonist to see it.

Technical analyst does not know where to LOOK. Sure he retorts with things like moving average crossovers, breakouts, triangles, flags and what not but my question still remains, why this breakout and not that one.

Would not it be better if you knew that you are buying a breakout in a company which has competitive durable advantage (which can be a compounding machine) or that the company which has had a moving average crossover is a value buy at current levels with inherent margin of safety.

Benjamin Graham did some awesome job in quantifying value and if anything technical fellas should appreciate it. Looking at charts as just lines is a fallacy, it is a story an unfolding movie and part ownership of companies is a better way of looking at things.

Value Investors can do better as well, Why do you have to catch a falling knife to know it hurts. Let the scrip fall, why can’t you buy it on its way up. You are anyways a long term player, a few points off the table won’t hurt you much would it.

Secondly, I don’t understand the way value investors define risk, according to buffet, possibility of losing your entire investment is RISK. Aping that mind set, almost all the value investors invariably over diversify. They would allocate 3% of their corpus on a given trade/investment. Even if they are right, it doesn’t change their monetary status. A 3% allocation on your portfolio becoming a multibagger is just an academic endeavor. Stop aping Warren buffet, he is a genius with insight and foresight, you are not. Period.

On the other end, betting 25% of your corpus on 1 conviction trade and defining risk as possibility of permanent loss makes you 4 bets away from bankruptcy and 2-3 bets away from RUIN (UNCLE POINT).

A stock price does not have to go to zero for you to figure out that the investment thesis was wrong. The tell tales will be there a lot earlier. Risk management as proposed by Ed Seykota holds a lot of value.

Define the % of money you are willing to lose on a given trade. Lets say 3% of your corpus. Now draw a line on your Graph, below which you think that the uptrend in the stock would end. Or if you are a hard-core value guy, put a figure below which you would think that the story , your hypothesis is WRONG.

Now do the invert calculation. 3% of your corpus, in our case comes to 30,00,000 *3/100 = 90,000
if the price of the stock is Rs 10 and you think below 6 (a 40% down move) would end the trend or question my hypothesis. will give me Rs 4/share as my defined risk.

The maximum number of shares that I can buy of this company is Rs 90,000/4 = 22,500. You don’t have to buy all of them at one go, but for the sake of example lets presume you did.

That comes to an investment of 22500 *10 = Rs 2,25000 which is 7.5% of our corpus.

At MYSTICWEALTH We don’t wait for 40% down move unless its a real conviction trade and so invariably our position size is bigger than 7.5% of our corpus on 1 trade. And that is the only way to get bang for you buck.

If you are right, you gotta make it count and if you are wrong, admit the mistake early and move so you don’t lose more than 3 odd % of your corpus.

Comments are welcome.