The Points of Failure
This post builds upon my previous post headlined “The Only Free Lunch in Finance” and attempts to shed some light on yet another critical aspect of risk. There is an assumption in financial theory that people will generally take less risk than more. This explains why many investors prefer fixed deposits or bonds over stocks. But I have often marvelled at how many people fall for the pitch of portfolio management schemes (often referred to as PMS in the financial services world or separately managed accounts as they are known globally) and individual stock ownership. This is because in both these cases you take on more risk (which people don’t like in general) and in all likelihood pay more taxes (which also people are not fond of).
Why does this happen?
The simple answer is that most people do not know how to assess risk. Sellers know this very well. They know investors only look at the performance and do not dig deeper into how this performance was achieved. Thus, there is a mad rush to flash performance (no matter how this was achieved).
From the second half of 2020, portfolio management schemes were aggressively sold, and many portfolio managers were touting their superior performance as compared to mutual funds. The pitch was mutual funds are for retail investors and portfolio management schemes are for high-net-worth investors. There were fancy names given to these portfolios to attract deep pocketed investors. Many even fell for this.
On the other hand, online retail stock trading platforms were going crazy encouraging retail investors to buy and sell stocks (trade). It didn’t make a difference to them (the online stock trading platforms) that trading was injurious to investor financial health and overall well-being. Crypto trading platforms were not to be left behind either. But who cares when everyone is making money? Investors don’t care either as long as money is being made.
How many people ask or are curious to know how the return was made?
Was this made by superior stock selection or by concentrating in a few stocks/sectors (called as overweighting) – by taking in more risk?
Most people are made to believe that these returns are achieved by superior stock selection. Thus, everyone ignores the truth until the bear arrives.
Take a simple look at the performance of portfolio management schemes now. They are disastrous because the point is that many had taken more risk to boost their performance. In short, many were on steroids. There was one who just had five stocks in its portfolio, but most have around 15-18 stocks. Though I have always believed that the only benchmark that matters is yours (based on your personal financial goals) and not some random one, I need to highlight (a point that you would know) here that a 15 stock portfolio can never be compared to a 50 stock or 500 stock benchmark.
So how should investors assess risk?
The following questions (not an entire list) are key from a risk assessment (and I am keeping the questions simple) perspective:
- Was the return achieved by concentrating in a few stocks/stocks or by building a diversified portfolio?
- Was any leverage used to achieve this performance?
- Was this performance delivered with the help of micro-cap or small-cap riskier stocks?
- Was this plain luck? This one is a very difficult one to assess but consistency of performance across market cycles helps to determine this.
- Do they tout a star manager? There is a lot of believable bullshit in this space because there are some very smart people who know the right words to use. Listening to some of them might make you even believe that he knows his shit, but the reality is that we live in an extremely uncertain, complex and fast changing world. The truth is no one knows the future. NO ONE. Period.
The only way to succeed in investing is by making as few mistakes as possible (easier said than done). This doesn’t mean one should take risk but as Howard Marks wrote, we should understand risk, recognize when it’s high and finally control it.
How do we recognize risk when it is higher?
The above 5 questions are a good starting point but let me explain this with the help of a term failure points and the popular children’s game “Chinese Whispers.”. In this game, players form a line, and the first player comes up with a message and whispers it into the ears of the second player. The second player then whispers into the ears of the third player and the whispering into the next player’s ears continues till the last person is reached. In most cases, the message that the last person comes up with is very different from the one the first player had whispered. This is because as the number of players increase so do the failure points in communication.
Similarly, in a portfolio, the fewer the number of stocks, the higher the points of failure because each stock is far more consequential to the performance of the portfolio.
Let’s take the case of Netflix, which has been the best performer of the last decade 2010-2020. In April 2022 though, the stock fell by 36% in a day and was down by 63% Year to Date (YTD). 3 Days back, there was news of Netflix firing another 300 people after having fired 150 employees earlier. The stock is down almost 70% YTD. If this is the case with the best performer of the last decade, what do you think can happen to other individual stocks?
Thus, I repeat this again – the fewer the stocks in your portfolio, the higher the points of failure. And you set yourself up for failure (by taking in a lot more risk than you can handle) the moment you make this decision. A bear market just proves it.
P.S. There is also the concept of risk adjusted return – compensating people adequately for the risk taken but I have left that out of this post to cover some other time (will do a separate post on this).