Tag: financial investor

Using Human Intelligence To Chart Your Financial Future

Nov. 11, 2020 3:14 PM ETAAPL, AMZN, ARKK.

Summary

  • Human intelligence is an under-appreciated ingredient in investing strategies and tactics.
  • The Federal Reserve has generally said that virus control is the factor that will help move the economy toward its potential, simple common sense.
  • Identify an investment theme or two that you can follow, a micro-focus, and monitor the forces impacting the macro-economy.
  • Build trust in your competencies by using your own “intelligence.”
Acacia tree

Human intelligence is behind everything, including artificial intelligence, machine learning, and the internet of things. We invest in technology as if it’s got a mind of its own but neglect what’s behind it. The intangible is becoming more tangible and also elusive in some ways. There’s an investment thesis building here, I promise.

We find ourselves at an inflection point in the world of human activity and in what to invest our time, attention and money. Human capital is increasingly valued in some sectors and industries more than others, except when management or leadership recognizes that the people it employs are the very essence of its model, like goods and services-oriented firms or those selling essentials like Walmart (WMT). Then you have the firms like Amazon (AMZN) and Alibaba (BABA) that use technology really well to scale for “essential” services and products. In a research paper about the valuations of firms with more intangible capital on their balance sheets, the study showed how the market and economy are evolving to include more of the FAANGs as highly valued firms, and why, which includes:

Apple (AAPL)

Alphabet and Google (NASDAQ:GOOG) (GOOGL)

Netflix (NFLX)

Facebook (FB)

The pandemic rewarded many of these firms for a period. Monday, Nov. 9 some of the more traditional firms were back in favor – oil and gas, airlines, and others battered by the pandemic. I’ve written about this since early February that COVID-19’s grip would continue to plague the economy until it was better contained and confidence restored. This current new normal is reflected in the Dallas Federal Reserve’s Index. The trend lines run to Oct. 17 and we know that cases have been rising in all states since that time. The Federal Reserve has generally said that virus control is the factor that will help move the economy toward its potential. It’s just common sense. I’ve participated in several Fed webcasts and read the assessments by various leaders.

Currently, epidemiologists and economics are co-mingling more in the mainstream of academia, trying to determine what pandemic economics look like and might reveal in the months and years ahead. The news by Pfizer (PFE) of their vaccine’s efficacy of 90% created the thrust behind the markets move early in the week as well as the election being called. The safety of their vaccine is now under review.

No lack of themes

Another investment theme is obviously climate change and sustainability, encapsulated by ESG (environmental, social and governance) actions by firms. All of the big investment houses are packaging ETFs and funds to appeal to the growing market for investments that help people and planet. That universe of types of firms is growing as are funds flows. Blackrock (BLK), Calvert and others like the American Century funds are increasing their offerings.

Morningstar noted:

Sustainable funds represented about 10% of all flows into U.S. stock and bond funds for the quarter (9/30/20). It wasn’t so long ago when that percentage was routinely below 1%. In September, sustainable funds comprised 24% of the $12.7 billion in net flows of U.S. stock and bond funds. Granted, September was a bad month for overall fund flows, but sustainable funds appear to be on a secular growth path that hasn’t experienced the same ups and downs.

My point is that we are not lacking in firms, funds and assets in which to invest as the ESG world shows. Note also that these funds can overlap each other’s holdings with other funds owned in a portfolio or 401(k). Duplication and thus concentration is an issue. We also witness “the market” being traded increasingly by algorithmic programs and momentum. What’s a human to do in this investment world of AI, the possibilities of technology, and behavioral economics?

Do-it-yourself themes

The pandemic has been like one of those apocalyptic series or movies where advanced technology and the basics of living are smashed together in an odd contrast to each other. Think TravelersInterstellarRevolution, and so forth. Our workforce is reflecting that as are our politics depending on what world of work you occupy to some extent. The big picture, macro, is a challenge to identify and yet, this is the very thing we require as a compass, particularly in the case of investing at this time. I believe human intelligence is the answer. It’s reflected in many a life sciences firm, ESG-leading firms, technology firms and yes, even oil and gas firms as they try to navigate an energy transition that is undoubtedly happening. British Petroleum (BP), Occidental Petroleum (OXY), Shell (NYSE:RDS.A)(NYSE:RDS.B), Enbridge (ENB) and others are finding unique paths within their scope of operations, asset mix and competencies.

No computer program will necessarily be able to identify “the future” though complexity science-types might disagree. The futurist’s impetus usually starts with a person having an idea or vision about the future. I believe we must use our human intelligence for this – sharpening our wits, focus and awareness. Inherent in operating from the theater of human intelligence is intuition, thought, and analysis that a computer or a Google search cannot truly penetrate. This is why analyzing data and finding inferences, data analytics, is a skill that’s in demand, the human side of the equation that finds meaning. Yes, I’ve been researching bitcoin investments of late. I listened to Raoul Pal’s “greatest trade” video endorsing the future of bitcoin. I’m currently intrigued by the Ark funds (ARKK)(ARKW) to name a couple of their funds.

I probably spend more time thinking about investing than investing, until I’m clearheaded about why I’m willing to bank on a stock or fund. Sometimes that does not materialize as success for many reasons – a sector falls out of favor, a black swan event or some other unforeseen circumstance. However, the portfolios I do have had held up from diversification and not acting (holding) as much as thinking (strategizing). Not pulling the trigger has been as equally important as pulling the trigger.

The best advice I can offer is to identify an investment theme or two (and/or their firms) that you can follow, a micro-focus, and monitor the forces impacting the movements of relevant firms and what is happening in the macro-economy. This will offer both risk mitigation and the ability to observe opportunities. The rest of one’s actions are about risk tolerance and investment horizon. Then, whether pandemic or not, there’s some forward movement or strategic plan when one’s timing is right based on your own human intelligence. The trust you build using your intelligence creates confidence for future decision making – your own human capital.

How Many Stocks Do You Need To Be Diversified?

By Logan Kane

Summary

  • Research shows that the typical investor has fewer than 5 stocks in their portfolio. This is not an effective way to diversify.
  • Why awareness of mean-variance optimization is better than shooting from the hip with your portfolio, and why owning more positions helps you let winners run.
  • Some interesting implications regarding owning your employers’ stock, short selling, and ETF vs stock investing.

Growing up, when the weather was too cold for golf, I would come home from school and watch Jim Cramer on TV. Cramer was a lot of my early education in the stock market, and his crazy sound effects and viewer call-ins appealed to my adolescent brain on winter days in Missouri. One of the first things I learned from Cramer was that you needed at least 5 stocks to be diversified. To the typical investor who owns fewer than 5 stocks, this is an improvement. However, years later, when I dug into the statistics of the stock market, I found that even owning 5-10 stocks causes you to take too much uncompensated risk. Furthermore, due to the nature of the distribution of stock returns, starting with high concentration will force you to make risk management decisions over time that cause headaches. I’ve found from my research that if you choose to invest in individual stocks, you should aim for 20-25 positions, meaning an initial max concentration of 5 percent in any one company. This gets your non-diversifiable risk to the point where if you’re good at picking stocks, you will know that you’re not just getting lucky.

The Problem With Concentrating Risk In Your Best Ideas

A common line from ex-investment bankers and hedge fund managers is that they like to concentrate their portfolio in their best ideas. However, if you look at the statistics of all the professional investors who do this, the group loses on average to more diversified investors. That’s to say nothing of non-professionals who concentrate risk. I found an excellent report from the research team at S&P which should be required reading for anyone picking stocks. Here’s what they had to say.

Concentrating portfolios, in other words, makes it more likely that good managers will look bad, more likely that bad managers will look good, and more likely that asset owners’ decisions will be informed by luck rather than skill.

In fact, there are clear conflicts of interest when highly educated (often clever but not always highly intelligent) fund managers concentrate their holdings. If they get lucky, investor money pours in, and if they don’t, they get another job at another fund somewhere. I’d conservatively say that 90 percent of the alpha in the stock market goes to 10 percent of the participants. If you’re not in the 10 percent, your best bet is to be lucky, which concentrating makes more likely.

The below graph makes this point clear. If you have an edge in the markets, it will show, and the more independent outcomes you have, the better you’re likely to do, luck be damned.

Source: Standard & Poors

Another immediate consequence and the one that you’ll typically see in the literature is that portfolios that are less diversified almost always have higher amounts of risk, as defined by standard deviation.

Source: Standard and Poors

You can compare the dispersion–or volatility of the typical single stock–to the volatility of the S&P 500 index (SPY). This is a historical graph but single stock volatility has been as high as 2000 and 2008 were in 2020. As such, a lack of diversification is a significant risk management problem in bear markets. The obvious corollary is that the fewer stocks you own, the greater the risk you bear.

One other issue is the extreme right tail in the distribution of individual stock returns. The median stock returns less than 5 percent, around a third return negative over the long run, and about 1 in 7 stocks return more than 20 percent annually. This general pattern holds true across different countries and indices. I’ve previously written about this, what researchers refer to as the “capitalism distribution.” What’s interesting about this also is that research shows the proper approach is to let your winners run and cut your losers, which is harder to pull off if you start with a less diversified portfolio.

If you start holdings at 10-20 percent and they grow massively, let’s say you bought Apple (AAPL) when the iPod came out, you start to have a problem. Your best performing stock starts to take over your portfolio. There are a few Seeking Alpha members who have shared their experience of their portfolio becoming almost all Apple over time. The issue is that you’re strapped into a roller coaster of a stock that’s performed great from point A to point B, but you’re utterly dependent on one stock, which in the case of Apple, has dropped 80 percent once in the last 20 years, 50 percent another time, and 30+ percent two more times. For more, I wrote about this in my article titled “Apple and the Disposition Effect.

What’s the best approach with all of this in mind? If your head is spinning by reading this, the answer is ETFs. With 5-7 ETFs, you can create a set-and-forget portfolio that’s backed by research and tends to outperform your neighbors who pick stocks. If you’re brave enough, you can take the same risk as your neighbors who don’t manage risk well and get extra return on a diversified portfolio via the use of modest amounts of leverage. Do note that since you need to itemize your tax deductions to deduct margin interest, this approach is best for those with a household income of $100,000 or higher, and only if you can borrow for less than a couple of percent per year in interest. What’s more effective is that S&P or NASDAQ E-micro and E-mini futures can offer a solution at a lower price point and a lower implied interest rate, however.

Some Pointers on Portfolio Construction

1. Owning less than 10 stocks exposes you to uncompensated risk. Since investors tend to gravitate to drama and volatility anyway, I would estimate the typical retail investor portfolio has a standard deviation of somewhere between 20-25 percent in a normal year. This is much higher than the 15 percent the S&P averages. By comparison, you could use futures to leverage the S&P 500 at 1.5x, rebalance monthly, and crush the typical investor at the same 20-25 volatility threshold.

2. Mean-variance optimization strongly outperforms random stock selection and closet indexing in reducing risk. There is some fancy software out there for this, but Portfolio Visualizer offers a lot of the same functionality for free. This might mean that owning something like Walmart (WMT) or Kroger (KR) is helpful in a downturn, or if you were savvy enough, buying work from home stocks like DocuSign (DOCU) before the virus shutdowns happened. Mean-variance optimization is not always an exact science, but being aware of industry diversification and correlations in different market environments help you reduce risk.

3. Short selling gets a bad rap but is statistically effective, but with 1/3 of stocks having long-run negative returns and the companies that do so having a lot in common (losing money, high debt loads at expensive interest rates, junk credit ratings), having a few short positions among your 20-25 single stock positions tends to help your portfolio’s risk/return profile. An interesting thought experiment is to consider whether it’s easier to buy the market and short the trash out of it or to short the market and buy the best. Research shows that 63 percent of the alpha is on the short side. The same rules of diversification apply as long-only portfolios, except short selling requires additional attention with regards to risk management. Selling calls on popular stocks that are failing instead of shorting directly also improves the returns from this type of strategy, because Robinhooders have bid up call option implied volatilities to levels that are not found in reality.

4. If you work a corporate job, own as little of your employers’ stock as possible, unless you’re getting stock options. Probability distributions of all the stocks out there indicate a roughly 2 in 3 chance it will underperform the S&P 500, and if you’re VP level or above, your economic fortunes are already somewhat tied to your employers’ success. Don’t do this, even if other people do! Most people don’t make much money in the market.

Conclusion

There are a thousand ways to make a buck in the financial markets, but one of the most popular approaches is one of the least effective. Owning a poorly diversified portfolio has a cost, and the larger the size of your portfolio compared with your income, the greater this cost is. If you want to play around with $5,000, be my guest, but if you have a sizable portfolio, it pays to professionally manage risk. If you’re good at portfolio management, embrace the opportunity to invest money in a higher number of stocks to improve the probability of having one or more long-term 10x winners in your portfolio. Be conservative with your portfolio construction so you have the flexibility to let winners run and cut losses, and the rest will take care of itself. Lastly, ETFs and futures offer the most bang for the buck, allowing for you to focus on leveraging and risk management for the same level of volatility, which is a far more exact science than picking stocks.

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Disclosure: I am/we are long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.