Bad Advice From Respected Investors Isn't Anything New

by: Damon Verial

Summary

On occasion I’ll see an article that advises a general portfolio or hedging practice that I see as outright wrong.

Chris DeMuth mentions three hedging strategies for preparing to protect your portfolio in the event of a market crash.

Let’s take a look at his idea and why I respectfully disagree.

When someone at Seeking Alpha makes a trade recommendation I disagree with, I might leave a question in the comments section. But it's ultimately up to the readers to decide whether the evidence supporting the thesis is sufficiently strong. I have no time nor interest to call out every thesis that seems counter to the truth.

However, on occasion I'll see an article that advises a general portfolio or hedging practice that I see as outright wrong. In these cases, I'll spare some time to write a counterargument. I've done so in the past on many options articles that call readers to buy overpriced puts or limit their profits via covered calls.

But now I want to call attention to Chris DeMuth's article on preparing for a market crash. On the surface, his hedging strategy seems sound. That's because it appeals to common sense, which we know is dangerous in the world of investing.

He mentions three hedging strategies for preparing to protect your portfolio in the event of a market crash. One, in particular, I feel is dangerous advice. If you've used Chris's investment style to make good returns, I advise you to separate his investment advice from his hedging advice, as I believe the latter will erase the returns the former brought you.

Let's take a look at his idea and why I respectfully disagree.

1) Position Sizing

Chris shuns the traditional philosophy of diversification: Put tiny chunks of your portfolio into large, unrelated stocks. I agree with Chris here; "hyperdiversifcation" is pointless. Not only does it eat commissions but it also rarely fulfills its goal of "diversifying" - the actual number of positions you would need to be diversified is much higher than the retail investor can sensibly invest in.

Instead, Chris recommends "doubling down" on the best investment opportunities, adding to your position at "better subsequent entry points." This is where I take issue. The statistics are on my side, as we are both talking about the risk-adjusted return of a portfolio.

Now, Chris recommends your portfolio to be one of uncorrelated partitions, thereby allowing for gains in each opportunity while still being "diversified" (i.e., market-neutral). To maximize the Sharpe ratio (and therefore return vs. risk) of a portfolio of such statistically independent investments, you only need turn to the Kelly formula. This formula is simple when dealing with uncorrelated investments and states L=m/V; the leverage (fraction of your equity) dedicated to an investment should be its expected returns divided by its variance.

Put simply, this implies that an investor should do the OPPOSITE of Chris's recommendation if maximizing returns versus risk is the goal. That is, reduce your exposure to a falling asset; increase your exposure to a growing one. This is also, notably, the opposite of what many fund managers do at the end of the year - selling your winners to ensure you are not "overexposed" to a… winning investment?

Indeed, Chris says the exact same thing: We want to avoid being overleveraged and therefore want to liquidate. This, again, goes against the mathematics and is an example of where common sense can hurt your bank account. The Kelly formula can tell you when and where you are overexposed; ignoring this simple formula (or being ignorant of it) in favor of a feeling can get you burned.

Chris ends this advice with another common sense recommendation: It's better to have more cash than the average trader, mentioning a cash allocation of 25% of your portfolio as perhaps "too low" but certainly "not too high". He explains this in more depth in his second section, but already we should see the problems.

Immediate are the arbitrary "25%" figure and the contradiction in liquidating during times of market worry if your portfolio is truly uncorrelated with the market. But behind these problems is a bigger one illuminated by using the Kelly formula: to minimize risk and maximize return, we should see that cash gives odd results here. The only conclusion that can be drawn is that the allocation of cash must vary per the benchmark use. And as each investor has his definition of risk-neutral, no one portfolio of allocation of cash makes any sense.

So, while the Kelly formula can be helpful in giving rules of thumb, such as to reject Chris's suggestion to "double down" on losing investments, it cannot accurately give us a position size for something on the extreme ends of "return" and "variance," both of which are roughly zero for cash. Still, the Kelly formula will, in general, tell us that less cash is better in a truly uncorrelated portfolio. Such a portfolio is not subject to market risk - and thus market crashes - after all.

I would like to conclude by pointing out that as useful as the Kelly formula is, the proper mathematical basis for portfolio sizing is useless if you are not psychologically capable of handling the swings in your portfolio. A working model works, regardless of what your portfolio looks like on a random Tuesday. The main concern I have for most investors is the impulsiveness to deviate from a working model in favor of spontaneous emotions and irrational advice.

I'm sure Chris has helped many investors; otherwise he would not be held in such high regard. But ultimately, we are all human, and the common sense that causes large losses in emotional can do even more damage when spoken from a figure of authority. If you're playing for the long-term, stick to the math, not what "sounds right."

Conclusion

The Kelly formula is a mathematically sound rule for managing the leverage of a portfolio containing uncorrelated positions (a la Chris's recommendation). However, while common sense dictates that we should avoid being overexposed in a certain position, the Kelly formula tells us to increase exposure as that position pays off, provided the risk profile remains the same or drops. Likewise, when a position fails, we should not "double down" but instead reduce our position size.

Notes:

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