“In every block of marble I see a statue as plain as though it stood before me, shaped and perfect in attitude and action. I have only to hew away the rough walls that imprison the lovely apparition to reveal it to the other eyes as mine see it.”
Sculpting was pretty straightforward for Michelangelo, he just took a chisel to a big block of marble and chipped away everything that wasn’t a statue. A similar approach can be used by investors.
My approach starts from an acknowledgement that managing a portfolio is first, last and always about managing risk. If we get that part right, the rest will take care of itself. There are some types of risk that we want to assume, in an effort to produce capital growth. There are other types of risk that are untenable. These are what we chip away.
- Illiquid securities. There is a school of thought that says liquidity is overvalued and that illiquid alternative assets like timber or farm land or investment partnerships with long lockup periods can offer meaningful diversification. Sometimes they do. But the downside can be horrendous, as many public employee pension funds found out in 2008 when their private equity holdings imploded. Illiquid investments can sabotage the effort to construct an asymmetric return profile.
- Single stock risk. Although I was a traditional stock & bond guy for most of my career, I am now convinced that the risk of devastating earnings surprises or management incompetence or outright fraud, etc. is too high to justify their use. Unless you can hold dozens of positions, the sudden and irreversible collapse of a single stock can take away years of gains. This is not just an issue for hobbyists and naive simpletons, some of the most sophisticated investors on the planet get blindsided with disturbing frequency.
- An over concentration in a single asset or asset class. Gold bugs should pay attention to this one right now. There is a long and well documented history of correlation between a sense of infallibility and financial wreckage.
- An undefined exit strategy. Investing by hunch and feel is ineffective. You have to have a plan and the will to follow it. Even when it doesn’t feel good. Especially when it doesn’t feel good.
Next up – Step 2: The Entry