Q: What happens when you add a risk free security with the efficient frontier?
A: You get the capital market line (CML). Theoretically you can choose the right mix of risky and risk free assets to create the highest return portfolios for each levels of risk.
Practically its a different issue altogether. In my 9 plus years of investing career I have not been able to figure out what to exactly do with this piece of information. Maybe we just move on.
Q. What happens when you diversify your stock portfolio?
A: You diversify away company specific risks and thus you are left with market risk. This is a nifty bit of knowledge because its pretty usable for everyone. It also goes well with the wise old statement of not putting all your eggs in one basket.
The benefits of diversification however start to come down after you own about 10 different stocks (this number can be slightly debatable). The value investing community (with some exceptions like Walter Schloss who owned a diversified pool of deep value stocks) generally believe owning concentrated portfolios that have a margin of safety is a better strategy. What is the point of owning your 50th best idea if you could buy your top 10-20?
Q. What happens when you combine other things?
Adding special situation investing like merger arbitrage or closed end mutual fund redemption to a portfolio of stocks can reduce portfolio beta as the outcome on such special situations are often not dependent on market direction. Adding a bond portfolio to stock portfolio can also reduce portfolio can also reduce portfolio risk (these two asset classes have often been negatively correlated) while maintaining most of the return. Adding a momentum strategy (buying stocks that have outperformed over a 6 to 12 month period) to a portfolio of deep value (low EV/EBITDA) stocks can ensure you still have a job after a prolonged period of under-performance by either of the strategies. For example being a value investor around the time of the Dot Com bubble has clearly sucked.
The above examples are clearly examples of good things happening. But just as combinations can create good they can also create bad. A pool of toxic mortgages will still remain toxic. And as much as Michael Milken claims that a portfolio of junk bonds aren’t as risky as people perceive them to be, he is quite wrong.
Q. No good story on investing is good without leverage, right?
Leverage is a double edged sword. It magnifies return and magnifies risk. Men always thought it could tame this wild beast called leverage but each time too much debt built up in the system it ended up in some sort of fiasco.
Yet this is where things start getting interesting. Let us look at Warren Buffett’s method of adding leverage. He used the float on insurance premiums to add leverage to portfolio. The advantage of this method is that there is no interest to be paid on the debt. It does however magnify risk and return just like conventional debt. But because Buffett adds leverage he does the opposite thing while picking stocks. He loves buying companies with extremely predictable cash flows with very wide moats. So predictable companies + natural leverage = high returns.
By chance I stumbled upon other examples of people who use this exact approach but in a very different context. Take the fabled quant hedge fund Long Term Capital Management. It put on mean reversion trades which had low chance of going wrong but magnified the measly returns with a mountain of debt. We all know how that story ended.
Quant shops have since then improvised. Although a secretive bunch some of them still use statistical or convertible arbitrage trades which lower risk and return to some extent. The low returns are then magnified using leverage. The difference this time is better execution and probably lower levels of leverage. It also helps quants to understand that models can never really mimic real-life and adds a degree of humility.
So leverage is like fire. If you are not careful you will be burned. Its not for everyone but often it is the people least able to understand it that sometimes tend to take the highest risk.
