Plan for Failure

Imagine for a moment that you are managing a large corporate bond portfolio for a major institution.  One of the first things you should internalize is that you will be wrong.  You will buy bonds of companies that will get into unexpected trouble, and their prices will decline.  Or, you play it safe as a panic deepens, and then as the fog lifts, you underperform because you did not hold onto risky bonds that would recover.

Face it: in volatile times we get it wrong.  We panic at troughs, and chase the rabbit when the market runs contrary to our bearish expectations.  But what do you do when you are on the wrong side of a trade?

The first thing to do is sit down with all concerned parties and ask their opinions.  (If you are working on your own, this point is moot.)  If everyone who has an opinion agrees, and the position still worsens, the final step must be taken.  Look at all external analytical opinion, and find someone that disagrees.  Circulate the disagreeing opinions out, and ask all concerned parties what they think.  Or, simply ask, what arguments have they made that we haven’t heard?  Do those arguments make any sense?  If they make sense, close out the position.  If not, it may be time to add more amid the pessimism.

But it is better to prepare in advance for bad times than to react on the fly.  Good investment processes plan for failure.  They realize that not every investment will win, and so they limit the downside of possible bad investments through:

  • Diversification
  • Hostile review when the investment falls by a given amount.
  • Limitations on size of positions.
  • Holding safe assets

Good investment management considers where asset values could go in the short run, and the possibility that money could be pulled if performance is bad enough.  But it also looks to the long run value of the assets, and is willing to sell when values are too high, and buy when values are too low.

As a corporate bond manager, when I got on the wrong side of a trade, I would call my analyst to me and ask her for her unbiased opinion.  If she was certain that things were good, and gave good answers to my questions, I would add to my positions.  But if she gave me the sense that things were falling apart, I would take my losses.

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When I went to work for a hedge fund in 2003, one of the first questions I was asked was  how I would position the portfolio.  I found myself to be the lone bull.  When asked why, I said that we were in the midst of a liquidity rally, and that short positions were poison when liquidity was adequate to finance marginal companies.  My argument was not bought, but I focused my part of the portfolio on marginal insurance companies that would benefit most from the liquidity wave.

Today, there are many bearish hedge funds that are licking their wounds.  What to do?

1) First, assess your funding base.  Estimate how much assets will leave if the underperformance persists.

2) Look at your positions relative to your expectation of prices two years out.  Eliminate the positions with the lowest risk-adjusted expected returns, whether short or long.  Keep the positions on (or add to them) that offer the most promise.

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Bad times offer an opportunity to concentrate on best ideas.  Good times offer opportunities to avoid risk.  In this time of liquidity prompted by the Fed, take the opportunity to lessen risk, because eventually the Fed will have to shift its position, and suck liquidity out of the economy.

1 Comment

  • “First, assess your funding base. Estimate how much assets will leave if the underperformance persists.”

    This is a key advantage that individual investors have over open end fund managers. For example, one of the stocks I’ve mentioned in a previous thread here declined after I first bought it, and ultimately dropped about 90% from my initial entry point. I still believed in the investment thesis, so I bought more all the way down, ending up with about 7x as many shares as I started. Today that stock is back above my initial buy point.

    There’s no way I could have done that if I were managing an open-end mutual fund. Everyone would have been pulling out there money when the stock was down 90%.