Employing Mentally-Constructed Portfolio Tranches To Manage Risk

Includes: SPY
by: The Mental Tranche Trader


Introducing the "Mental Tranche" approach to managing capital and risk (it is not necessarily a buy-and-hold strategy).

The approach serves to counteract investing emotions by helping to provide some boundaries around the definition of success and failure.

A new Mental Tranche demonstration portfolio returned 2.76% for July (versus 3.49% for SPY).

Confession. I like to play with my portfolio. I yearn to be free, to buy every good idea I read about, and churn baby churn that portfolio. But conventional wisdom frowns upon short-term churn. With absolutely no rigorous data set to back me up, I assert this is because conventional wisdom tends to assess risk in terms of outsized returns over long periods of time rather than modest returns over significantly shorter periods of time.

I respect conventional wisdom-I've had success following it-but to my mind it is all very faith-based and religious. The choir sings the praises of the apostolic Graham and Lynch and Buffett, and that Investor's Business Daily guy with his cups and handles, and countless others, which is in turn retched out as dogma by rabid followers. [Take it easy gentle reader...this is satire to some extent.] However, like any belief system, there are seemingly irreconcilable philosophical skeins surging through the conventional milieu, owing to one of the more popular investing tenets out there: be contrarian...sell when others are buying, buy when others are selling. One supposes we all yearn to channel some inner Archibald MacLeish lurking inside, even though to go your own way would violate all those decades of investing canon and invite heaps of prophetic doom and gloom from the learned Priests of Investoria. They shoot first ("if you're so smart with your upstart ideas, then where are your billions?") and never ask questions. Belief systems do not like questions.

But we're not billionaires, are we? Our investing needs are not those of the billionaires'. Which brings me back to my confession: one of the things I need is a sandbox to play with investing ideas, money management theories, and the like. A sandbox with real money, to test real emotions like the thrill of victory and the agony of…..well, you know all of the stock-market-as-blood-sport-combat metaphors.

Over the years I've engaged in buying, holding, swing-trading, dividend capturing, covered-calling, naked-putting, calendar-spreading, reverse iron condoring, etcetera, etcetera, etcetera. And I've variously held positions that performed okay, good, pretty darn good, fabulous, poorly, and embarrassingly poorly, I am sure much like every other investor with a couple decades' exposure to the markets. Always, during this time I've been thinking about risk and capital management, and working over in my mind how to reconcile the two. We can always fall comfortably back to the Church of Conventional Wisdom Investing Acolytes (CCWIA), who state unequivocally that diversity and time is your friend for managing both risk and money. Studies and statistics and all manner of academia I'm sure bear this out (hopefully with non-tautological premises), assuming one diversifies with the right stocks to begin with.

And now, a disclosure. I invest predominantly just like the CCWIA would have me do. Yep, for the bulk of my cash and retirement accounts, I've invested like the typically diversified, value-seeking, cost-averaging, dividend-growing and dripping, close-my-eyes-and-throw-a-dart buy-and-holder because, well, who am I to seek alpha outside the conventional? The thing is, I, like many of you, have read so many market gurus it feels like I belong to too many investing sects. I become seriously self-conflicted when my various follower-personalities attempt to evaluate any one equity position through the good works of all those learned monks. It can make one mental.

Dig a Mental Tranche

What's a tranche, anyhow? Here, I've Google'd it for you:

Screenshot 2016-07-22 at 4.20.21 PM.png

The Too Big To Fail financial crisis last decade introduced a lot of us to "tranches" as bundles of securities (like mortgages and derivatives of mortgages) that can be split up (and recombined, it turns out) into myriad pieces and sold to (unsuspecting?) investors at the risk of an inadequately-leveraged banking system that, upon collapse, would usher in the next dark age. Tranches bad. Bad, bad tranches.

But, no! Traches are also good for purposes of our little thought-exercise here. Let's mentally visualize the cash in our sandbox portfolio1 split into 10 tranches, where each tranche represents 1/10th the value of that free cash. The investment goal for each tranche is straightforward: grow each tranche 1% per month for the 12-month period beginning July 2016. If one could maintain this growth throughout the year, then by June 2017 each tranche would have grown 12% (we're obviously not compounding the growth here).

Let's put some real-world numbers on this. A really boring and safe fractional portion of my ROTH has been sitting in Certificates of Deposit, annually yielding a ginormous 1.2%. On July 1st, 2016, I took that portion, all $45,586.09 of it, moved it over to a brokerage, and mentally placed it into 10 separate equal-sized pieces ("tranches," if you will). Ergo, each tranche on July 1st was worth $4,558.61. The goal according to this Mental Tranche Trading scheme is to grow each tranche 1% or a mere $45.59 per month. At that rate, the entire portfolio would grow roughly $455.90 per month and $5,470.80 by June 30th, 2017.

To assist in the journey to next July, I've constructed some Mental Tranche guidelines:

  • Each month, establish (if possible) a separate position in each tranche. It stands to reason that the most open positions I could have at any given time is ten.
  • Close each position after 1% gain…that is, exit (or seriously consider exiting) the position when a $45.59 gain (net of commissions) has been achieved.
  • Do not count unrealized gains/losses in your 1% return calculations. Only closed positions count towards the 1% return calculations.
  • Any dividends earned can be used to count towards the 1% (when they are paid).

This is Not a Stock-Picking System

The Mental Tranche Trading approach concerns itself with managing risk2 and capital, rather than with what stocks to pick or how and when to pick them. Although, let's face it, the monthly 1% target encourages shorter term trades which, in turn, would certainly influence the stock picking.

So how does it manage capital and risk? Okay, hold on, here comes the inevitable pie-in-the-sky wishful thinking part of the article: The Mental Tranche Trading capital- and risk-management technique serves to counteract investing emotions by helping to provide some boundaries around the definition of success and failure. It provides a way of looking at investment capital that may permit easier attainment of capital growth goals and is intended to make trades relatively less speculative and more conservatively tilted towards modest success. The Mental Tranche Trader will miss some great gains by bailing out of winning positions at the earliest whiff of success, and will inevitably take some ugly losses as well. Remember, we were earning 1.2% in CDs, so anything above that at the end of a year of Mental Tranching is a win.

Naturally, there are practical implications of short-term trading, two of the obvious related to commissions and taxation (presented in this faux Q&A format):

Q: But won't short term trades generate lots of commissions for my broker?

A: Yes! Lots and lots of commissions. Watch for them! It will drive you nuts, especially as you must account for them in calculating entry and exit points to get you that 1% per tranche per month. You can maybe negotiate a better commission with your broker or find a flat annual (or monthly) fee brokerage for unlimited trading if that's important.

Q: Won't lots of short-termed trades and non-qualified dividends result in higher taxes and IRS-documentation nightmares?

A: Perhaps, yes. The impact will vary across tax-advantaged and cash account types. I say, go forth and research the implications for your own specific situation.

So, are you muttering "good luck, buddy!" under your breath yet? You should have by now! While you have just been introduced to this hare-brained scheme, I've had a bit longer time to get used to the method, trading variations of it for a few years and having success, for example up 11.5% in an options trading account through the first 7 months of 2016.

Tranching in July 2016

Okay, back to the $45,586.09 balance of July 1st. How did the mental tranching of these funds go? Well, realized gains (positions closed and dividends paid to the account during July) amounted to $1256.20, which is a 2.76% gain over the opening balance. Moreover, we have an additional $447.75 in dividends coming our way in August. Remember, we are aiming for a minimum 1% gain to stay on track for the year, so we beat the $455.90 monthly goal by $800.30. We earned more coin in a single month than those bloody CDs would have provided in an entire year..."huzzah!" for making the change.

Here's how individual tranches performed:

You'll surely note that 30% of the tranches (T-2, T-6, and T-10) failed entirely to meet the 1% goal. That's pretty typical in my experience with this approach. That 4 of the tranches more than tripled the 1% goal is fairly unusual, though, although you can almost always count on one or two tranches being stellar on any given month. The good news about having a strong first month is that our 2.76% return is roughly what we would need by September 23rd, so we can return flat between now and then and still be on track for the year.

As hinted earlier, this approach encouraged shorter hold times for the positions established. The average hold time across all positions closed during July was 5.14 trading days. Consequently, these shorter hold times allowed for more diversity: each of the 10 tranches hosted at least 2 separate positions (invested sequentially, not simultaneously). Thus, the entire portfolio was ultimately invested in 24 different stock positions, 14 of which were closed in July. It is important to note: if you do not have an annual or monthly flat fee trading account, the 38 trades at $9.99 each would have sucked $379.62 out of your $1256.20 gains.

The 20/20 hindsight view is that a simple buy-and-hold approach in the SPDR S&P 500 Trust ETF (SPY) outperformed all the Mental Tranche machinations described above. Had all 10 tranches entered SPY positions on July 1st and closed the SPY positions on July 29th, the portfolio value would be $1,568.16. Of course, the risk is that all 10 tranches would have been 100% invested for the entire 20 trading days of July, come what may. Contrast the average percentage of cash invested over the course of the same 20 investing days while Mentally Tranched: about 54%. Moreover, the Beta average for the 24 positions was .91, so a teensy bit less price volatility among the Mental Tranche-invested stocks. Thus, lower cash invested and volatility risk = lower returns, yes fellow worshipers? In any case, please raise your hand (or levitate) if you knew on July 1st that SPY was going to jump 3.49% in July.

By the by, I've been documenting individual positions taken while using this approach with screen shots of my buy and sell orders. I've also posted a list of positions taken and provided other summary info for July here. I share for purposes of Mental Tranche Trading demonstration only. So, you know, caveat emptor.

[1] Let's assume one's sandbox portfolio represents about 2-to-5% of their total investment holdings.

[2] Not so incidentally, we all know that measuring "risk" is difficult enough: decades of market academics haven't settled on a definition. Popular Web sites like Investopedia exhort investors to "think of risk in terms of the odds that a given investment (or portfolio of investments) will fail to achieve the expected return, and the magnitude by which it will miss that target." This is a useful construct for conceptualizing risk, although it clearly does not free the investor from subjectively defining "expected return" and "magnitude" of potential loss. Alas, "risk" must remain defined by the individual, with their unique time horizons combined with expectations for gain and tolerances for loss. Mental Tranching does not depend on a universal definition of risk, but it does require the individual investor to thoroughly understand their own expectations and tolerances.

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. I have no business relationship with any company whose stock is mentioned in this article.