This post was spawned by a discussion I kicked off in the YONG board around the construction of portfolios ... in particular the concept of baskets and their uses in this service.As an intro: Whilst I generally acknowledge the usefulness of diversification, I feel that there comes a point where it becomes in effect meaningless. The following is from an email discussion:Re the basket approach - I made a post reply to that earlier today. My main concern here is that you're effectively trying to combine something very high risk with something that almost equivalent to US market risk (e.g. KO) in an attempt to diversify and reduce risk. That's fine as far as it goes but you're also diversifying out return potential. So, in the end, even with potential of 100%+ returns, you have a choice: you either have a meaningful position of the high-risk stock as part of the basket or you may as well not have it because even returns of 100% or more don't move the needle in terms of the basket return enough.It's not that the concept is wrong, it just that when you hit extremes that it doesn't quite work so well for us humans ... it's a bit like the frequentist fallacy in statistics ... unfortunately, we can't repeat the 'experiment' thousands of time and thus simply thinking in terms of expectations isn't the most useful decision support tool. In this case (YONG), either the stock pays of big, or it craters, or it does nothing (ignore this one given uncertainty). So with a likelihood of potentially large losses (e.g. fraud) and a correspondingly low weighting in the basket your overall return benefits very little from extraordinary returns, should the long thesis be right. Another way to look at is that for cases where the extremes are fairly likely, you don't really benefit from diversification as that is an 'on average' concept, whilst you care for the one binary outcome only. Reverting back to frequentist thinking one could say that the expected payoff is too small to be worth the bother. Therefore, it seems to me that it would be better to treat these types of stocks completely differently with respect to the advice given by the service - pull them when there is (necessarily subjective) signs of trouble and only re-recommend once that has been cleared off. (It doesn't help labelling them 'ultra high risk' and reducing their weight in a portfolio as such, see above argument above.)Note that this commentary pertains to only a specific class of stock: Highly speculative EM with a history of fraud and manipulation, in particular, China stocks - not the likes of ITRN, etc.What do other members think?C.
So with a likelihood of potentially large losses (e.g. fraud) and a correspondingly low weighting in the basket your overall return benefits very little from extraordinary returns, should the long thesis be right. Another way to look at is that for cases where the extremes are fairly likely, you don't really benefit from diversification as that is an 'on average' concept, whilst you care for the one binary outcome only. Reverting back to frequentist thinking one could say that the expected payoff is too small to be worth the bother. Hi No Fate,Although, as described below, I do not necessarily agree with you on all points, I welcome your thoughts and discussion. In 1939 Sir John Templeton bought 100 shares of each stock that was trading for less than $1. One could make a “frequentist” or “inconsequentiality” argument about each of these purchases, but one probably wouldn’t at this point, because Templeton earned massive returns from this strategy in four years.I mention this because I have been taking a different “basket” approach to risky small caps (including Chinese companies such as CGA and YONG) – namely, I invest in baskets of such stocks that have met certain quality criteria (such as being vetted by TMF). And, quite honestly, I take the advice of the three GG advisors very seriously; of course there are no guarantees, but the odds shift dramatically in our favor, I think, in cases where the GG team has really looked at a company over a period of time.Anyway, my baskets do not typically include companies such as YUM and KO (although I do invest in such companies, actually in fairly sizable chunks, using my options/dividend strategy, which an interested Duke Street member could find at http://boards.fool.com/1228/the-bitb-stock-rejection-machine... ). Instead, I have two “Templeton baskets” – one consisting of dividend-paying small caps and the other consisting of other small caps, all meeting certain quality criteria.I emphasize income production in my portfolio (not because I need the income, but because I think it is a good total return strategy in what I think might be a long muddle-through “New Normal” period). Thus, my Templeton Basket strategy is as follows:1. When I identify a company that meets my criteria, I make a small initial investment.2. For companies in the dividend-paying basket, I add on dips.3. For companies in the other basket, I add (i) usually on whole-market declines that are significant and (ii) occasionally on large individual company declines if my investigation (generally consisting of reading Morning* and TMF analysis) suggests it is not a merited decline. I have added to my YONG holdings on this basis.4. The baskets as a whole remain a small portion of my portfolio, but I am prepared to let them rise to up to 30% in total if there is a major correction. I imagine there may ultimately be well over 100 stocks in the two baskets, combined.Again, I recognize that one could make frequentist arguments against this strategy. I have little theory to offer in response, but can instead point to Templeton’s success and my own returns from this strategy over the past few years. (I invested heavily in my small cap baskets in Mach, 2009 and sold almost all of the basket stocks recently. Here is some evidence to support the preceding statement: http://boards.fool.com/1008/politics-opportunity-27491810.as... )All of the foregoing was just describing an alternative basket approach for discussion. Now let me revert to your particular criticism of the MF GG basket approach. The theory of these GG baskets is much more of a “rifle shot” theory than would apply to a Templeton basket. The GG team identifies a particular secular trend and then designs a layered approach to investing in that trend, with a large safe component and a smaller risky component. I think your “game is not worth the candle” argument against these GG baskets suffers from the same problem that would be present if you applied it to a Templeton basket approach – namely, it considers each risky element separately without summing their aggregate effects. There are a number of different baskets, and the aggregate contributions of the riskier elements thereof could easily be quite significant (as in a Templeton basket experience). Also, I think your argument might be more compelling at a time when returns from other strategies were higher. These days an extra half a percent return might be a 50% increase in returns for a year (sadly). Finally, sure there is fraud risk in companies such as YONG, but risk is risk – I care less about the adjective in front of the word “risk” than I do about the risk-adjusted return from an investment, as best we can calculate it. As Bill Gross points out at every opportunity, investing in US treasuries for 20 years is likely to result in the loss, in real terms, of maybe 60% of the invested amount. To me, that is in some sense riskier than a basket of YONGs!So, I am quite happy with the GG basket approach. Of course, there are members of the GG community that I have come to like personally who I fear are heavily overinvested in the riskier components of these baskets, and I actually find myself worrying about them from time to time. I am not sure what more the advisors could do to avoid this problem, but perhaps this is an argument in favor of your approach.RichBITB
Hi RichI think you may have misunderstood - your Templeton analogy is misplaced, he invested in an equal-weighted basked. The GG baskets are advocated to be weighted according to risk rating. Sir John implicitly accorded all the same risk and, of course, did very well out of the ones that made stellar returns ... more than compensating for those who went bust. If you believe that the highest risk picks also offer the largest potential then you get to the conundrum outlined in my posts.C.
Here's some of the original scenario analysis surrounding how I was thinking about it. Obviously, these are exercises in futility in some respect because if we could predict the future, we would invest 100% in GMCR or some such. Since we can't, we play with probabilities and diversify.I find it helpful in situations like this to try and work in specifics rather than abstracts, so I'll use the Rural Boom basket as originally constructed. Here was how we laid it out (assuming $1000 total invested).YONG $400CGA $200CMFO $100KO $150CHL $150Those weightings were chosen at the time to represent our assessment of total return potential and risk profile, with KO and CHL serving to help ballast more volatile elements of the portfolio. As for KO being equivalent to US market risk, note that we believe we are analyzing KO differently than other analysts and that it is not the proxy for US market risk that others might believe given its massive EM exposure.Here were my best guesses at the likely best and likely worst case return scenarios for these stocks (leaving fat tails aside):YONG -100% to 25% annually for 5 yearsCGA -100% to 20% annually for 5 yearsCMFO -100% to 20% annually for 5 years (though we didn't know the company as well as CGA)KO 8% annually for 5 years to 10% annually for 5 yearsCHL 5% annually for 5 years to 12% annually for 5 yearsGiven the weightings above here's how the returns might have unfolded over a 5 year period.Best case (everything achieves its best case scenario): +147.8%Worst case (China small caps all go to zero, KO and CHL underperform: -58.8%Realistic case (one China small cap goes to zero, two underperform best case, but do well, KO and CHL do 10% each): +75.8%If we run those same scenarios using an equal weighted portfolio, here are the results.Best case: +128.5%Worst case: -45.1%Realistic case: +57.3%And if we just invested in KO and CHL:Best case: +68.6%Worst case: +37.3%Realistic case: +57.5% All of this is to say that I thought our construction would give us a chance at significant upside without magnifying our downside risk provided you accepted the premise that we should invest in some Chinese small caps. If you reject that premise outright and don't have a sufficient time horizon, then the right move is to build an equal-weighted portfolio of blue chips with EM exposure.As for the results thus far of the basket (including the re-balancing we recommended on 11/9/09 and the switch from CMFO to CMGHY), here they are approximately 1.75 years in:Rural Boom Basket: +11.8%FXI: +5.1%SPY: +38.6%My observations here are that while we are beating our China benchmark, perhaps that gap is not wide enough to compensate for the additional risks we are taking. The argument against that is that there are some market forces acting against us and that the fact that we are outperforming despite our exposure to small China actually lends credibility to our approach -- and we should expect that gap to widen if we have chosen wisely in small China. The other meta force here is US outperformance. Obviously, that hurts us, but hopefull you are 40% to 60% invested in the US and have benefited from this and are not relying on China to fuel your portfolio growth every year. This is where country diversification comes in -- and I encourage people again to read our global asset allocation report. I'd be lying if I said I thought this basket would be up just 12% almost 2 years in, but given where we are and how we've gotten here, I am contemplating throwing out our approach. Tim
I'd be lying if I said I thought this basket would be up just 12% almost 2 years in, but given where we are and how we've gotten here, I am contemplating throwing out our approach.Important word missing ALERT. I am *NOT* contemplating throwing out our approach.Tim
Hi TimOk - I see I got that backward - i.e. I assumed YONG etc were the kickers to the portfolio, not the drivers but you actually constructed it in a somewhat strange way that seems to be related to the risk you see but with a lot of 'gut feel'.E.g. you give same CGA and CMFO the same return characteristics but give CGA twice the weight."All of this is to say that I thought our construction would give us a chance at significant upside without magnifying our downside risk provided you accepted the premise that we should invest in some Chinese small caps. If you reject that premise outright and don't have a sufficient time horizon, then the right move is to build an equal-weighted portfolio of blue chips with EM exposure."Tim, but that depends very significantly on the probabilities you assign to the outcome - in other words, whilst your numbers acknowledge the possibility of -100%, justifying your argument above only works if you also assign a fairly small chance of the 40% of the portfolio ending up as 0.Ignoring for a moment that hindsight is 20/20, I think we can all agree that Chinese small caps are an identifiably risky asset class. As such, I think the conclusion here would be that the probability assessments were too optimistic?With respect to moving forward then ... basket construction even this way around, suffers from the problem I outlined above: If you have 'only 30%' as ballast then that ballast doesn't provide that much buffer ... even if they do well at 10%, if you have non-performance or negative performance it turns out pretty ineffectual (at 0% for the 70% you end up with 3% total return, at a catatstropic -90% you end up with a 60% loss for the portfolio). I would have to scribble this out on a piece of paper but intuitively I think if you look at the maths you can probably formulate some limiting function to this ... irrespective of whether you look at ballast or kicker - I suspect (pure gut feel for diversification mechanics) that the key driver here is how wide the spread of the range of outcomes is. In other words, you get the usual expected results (diversification is good) if you combine things with fairly similar characteristics, if you combine things that behave very differently I think you end up with results that are difficult to stomach, in the sense that you either end up with much less protection than you might think (unless you strongly discount negative scenarios) or with much less upside to make it worthwhile researching the stock. If there are any members here that a more fleet-footed with stats than me, please weigh in.Thoughts?C.
I think we can all agree that Chinese small caps are an identifiably risky asset class. As such, I think the conclusion here would be that the probability assessments were too optimistic?This is where I think this discussion veers into the realm of the academic. The answer to your question is, yes, provided we assign an equal probability of zero value (fraud) to every name in the sector. The real-world counter would be that we can identify variable probabilities based on certain qualitative factors uncovered via further study. Some of those might include the presence of a Big 4 auditor, verified operations and channel checks, etc. For example, while CGA and CMFO offered the same return potential in the example above, I thought we had a better handle on CGA, its business, and management team.One reason why I think there's still opportunity in this sector for "choosy" investors like us is because the sector is all being treated the same. For example, Roth's price target on YONG is derived by multiplying their EPS guess by 5 -- the average P/E for the sector. Of course, as I've said before, 5 is a stupid multiple to apply. The right one (if you believe in applying multiples at all) would either be 0 (fraud) or something higher (a verifiable growth business). The stocks -- as theory would tell you -- are all being treated the same, but they probably shouldn't be. Some are disasters, and some are not. We've seen some disasters first-hand in China and talked with the CEOs of those disasters. I can say that those have been different experiences from what we experience with, say, Yongye.if you have non-performance or negative performance it turns out pretty ineffectual (at 0% for the 70% you end up with 3% total return, at a catatstropic -90% you end up with a 60% loss for the portfolio).This is why we spread our exposure to the small Chinese stocks. I generally thought that no matter what our diligence we would end up with one disaster (a 66% percent batting average would be great, but the risk of getting one wrong was likely catastrophic). This is one reason CMFO was replaced by Chaoda -- a much larger company -- rather than another tiny one. Ultimately, I though we had been too aggressive originally. On the bright side, we initially benefited from that risk and rebalanced before it really bit us.you either end up with much less protection than you might think (unless you strongly discount negative scenarios)Again, the key here is that these are not randomly chosen companies, but companies that we believe, based on our work and multiyear study, have a better than average probability of not delivering a negative scenario. If you think our analysis is flawed, though, and have no better than average chance at avoiding a RINO, then the basket will not protect you. Its goal, rather, is to help investors hang in there with something like Yongye, that in terms of its role in the portfolio, while volatile, is a worthwhile long-term holding. Tim
I view the basket approach as a psychological tool recommended by the GG team to help safeguard us from the stress caused by the volatility of the Chinese microcaps (judging from the boards, it has not been very successful in that regard).Mathematically, a 40% allocation to YONG as part of a basket designed to comprise 5% of a portfolio is no different than a 2% YONG position in the overall portfolio, and one is either comfortable with that or not. If not, one should either take a lower allocation or simply not own any at all. When it's put in a basket, it masks the volatility, but to what end? To trick one's self into feeling comfortable holding a more volatile stock than one is comfortable holding? That sounds like a recipe for disaster. If one is not comfortable holding a 2% YONG position, one should not hold a 40% YONG allocation within a 5% basket.On the other side of the coin, I would not personally bother holding a 1% position in KO (i.e., a 20% allocation within a 5% basket). I want a (full) 3-10% position or none at all (or, if I want a basket with KO, I'll just buy a low-cost index). This is partially because of transactional costs and partially because I want a concentrated enough portfolio that I can keep on top of all of my holdings--which, for me, means less 40 total holdings. For Chinese microcaps, 0.5-3% overall position sizes make sense given the risk, but--to make up for that--positions that are less risky must have heavier weightings.The first week the WSJ launched their weekend investor section, there was an article on how to get more out of the cash position of your portfolio. Their recommendation was to allocate some of your "cash" position to bonds and high-yielding equities, but still consider that part of your designated "cash basket." That makes no sense and is the worst financial advice that I have ever heard. Obviously the China baskets are vastly different in that they don't try to hide risk, but they do add a layer of opacity, and I cannot help but think that is a bad thing.I don't use the basket approach per se, but I do have a collection of small positions in risky Chinese microcaps (I similarly have a couple of similarly-sized positions in speculative alternative energy companies). That being said, if the team wants to keep recommending them as a tool, I have no problem with that; in fact, I welcome their recommendation of baskets if it enables them to cover some attractively-valued companies that they would otherwise not feel comfortable covering.NoFate, if I understand you correctly, your issue is twofold: first, with baskets' effect of adding opacity to risk taken (as I discuss above and agree with you). Second, your issue seems to be with Chinese microcaps generally--that the risk is so high that an appropriate weighting would be so low (say 0.1% of a portfolio) that--even if the stock were to triple--it wouldn't move the needle enough to justify the risk and/or hassle. Your second issue is more a reflection of your personal risk preferences than anything else, IMO. It is a fine and logical position to have, but I believe that there are other risk preferences that are also fine and logical, and I think that the team works hard to run a service that accommodates a range of risk preferences--which is good.After having a spectacular (but almost meaningless to his overall portfolio) failure in XPRT, hedge fund manager Whitney Tilson has some extremely applicable things to say:http://www.marketfolly.com/2011/03/whitney-tilson-explains-l...Returning to YONG specifically, I actually think that it looks like a more attractive investment now than in mid-2009 (on a price- and risk-adjusted basis), so I find it interesting that your analysis and risk preferences lead you to conclude that it not worth owning now (though presumably you felt it was worth owning at some point in the past):http://boards.fool.com/1106/poll-yong-a-more-attractive-buy-...-Sean
Hiya"One reason why I think there's still opportunity in this sector for "choosy" investors like us is because the sector is all being treated the same. "I absolutely agree with that - but I think your argument from the start of your message is getting a bit side-tracked with respect to the assessment of probabilities. What my statement referred to was the assessment of probabilities of the return scenarios for the basket chinese small cap stocks, these have already been positively-selected by the team against the rest of the 'potential fraud cases' (or less harshly, the remaining chinese small caps that offer a less favourable risk/return potential according to your research, familiarity, etc.). It is therefore neither academic, nor is it not real-world -- nor does it imply an equal weight for all chinese small caps when one agrees that as a class (now not just the basket ones) they are high risk. Maybe I wasn't very clear on this in my first message.To make this practical - let's skip to the end of your message. If you assume that you do have selective ability (though not perfect) [which I do otherwise I wouldn't be a paying subscriber] and so you are choosing stocks that you believe offer better than average (=equal weighting) returns and you further weight them according how comfortable you feel (risk/return, handle on management, etc.) then you are still making at least an implicit assessment of the probability attached to each return scenario. You've given various figures in your messages and spoke about expecting one complete fraud, what I was trying to say in my previous message is that from all I can reconstruct out of this (a) it is simply the case that the assessment of likelihood of returns (to date) was overly optimistic (b) it appears to me that you assigned an insufficient weight to catastrophic scenarios for otherwise you would've constructed the basket different.I am not trying to 'finger' you for being wrong - merely trying to point out what the choice made imply (which in itself is not 'fair' in the sense that we're comparing an ex-ante assessment that could've played out as an infinite set of scenarios against the one and only one that materialised.) ... and trying to maybe give you some thoughts around probabilities (it's a topic most humans are dreadful at).So, let me put it differently:(a) Yes I do believe that the team has a much better than average chance at avoiding a RINO, CCME, etc.(b) Because the class of stocks you draw from is treated all the same by the market you will be able to generate excess returns, given (a)Important part:(c) However, given the fact that the baseline probability of fraud/catastrophic loss for the class of entities you select from is much higher than normal you also need to adjust your posterior assessment of that risk after you've done your analysis to a level that is higher than, say, if you had started with US stocks (if you want consistent probability assessments, which everyone *should* want)(d) You can express this assessment in many forms, for the present argument I think it is most conducive to look at it as a fat tail to the -100% return.(e) Given (c, d) you now try to construct a basked to take away some of that risk - this whole depends on your assessment of the probabilities for each scenario. For the sake of simplicity, let's assume it's only chinese vs. US stocks and the US stocks don't move much and give somewhere between 5 - 10%, the Chinese give -100% to +25%- Your portfolio construction with a high weight to the latter class implies that you did not believe that anything <0% was very likely, otherwise, why assign so much weight? At 0% you end up with a very low portfolio return and this is fairly stable because the return spread on the US stocks is fairly small, so most of the 'probability' mass in the distributions of outcomes you assume has to sit above the zero line for you to end up with something that's desirable. The downside to your choice is that if you strike out on the wrong stock, you've sustained a 40% loss (as per your portfolio), maybe more, maybe less depending on what the other chinese stocks return (again, the US stocks don't swing this much given their weight). So again, for your expectation to work out to something reasonable, you had to assign a lot of mass to the distribution above 0, with a big chunk sitting right up towards the positive side of your return expectation. That, however, is not consistent with (c). There is no precise formula here and it cannot be optimised generically but only for each individual's combination of assessed probabilities, loss aversion, etc. I do think, however (and you've admitted as much in your email) that this didn't go the way you expected but I would posit that this is not just because the market chose to go this way, but also due to the way the portfolio is constructed. - The second point I'm making in these messages is that not only do the assessed probabilities appear inconsistent with (c) above but also that the construction may be inefficient. Put another way, precisely because you're faced with such different animals, will you not be able to find a combination that gives you both diversification of risk and returns that are worthwhile in combination that you could not get with a simpler construction (less transaction costs, research time, etc.) In the above example, the US stocks provide 'ballast' but in the scenarios you really care about they don't play that much of a role, so you may as well skip them. In my original understanding of the basket (higher weight to US stocks) [and yes, I know, KO's revenue are increasingly EM .. using this as shorthand only], you end up with a similar problem in that in one of the scenario you really care about (really good) you are not generating enough of an outperformance, being weighted down.This is a very long winded explanation for the simple fact that I believe the numbers you have provided indicate that the probabilities assigned to very bad outcomes are too low and that baskets don't really work if you're putting things together that have very different return profiles (unless you correct for it by adjusting your probability assessment to give only a narrow range of outcomes that's likely). From a stats perspective, you combine two variables one with a small variance, one with a large one and you end up with a point estimate and still pretty big variance. You've gotten around this by simply reducing the variance of one of your inputs, but that is imprudent. (Note that this doesn't imply some sort of equal weighting, which we dealt with above ... it is just the case that given your research you felt comfortable and narrowed the range of likely outcomes away from -100% more significantly then looks to be justified given the baseline levels of probabilities of all things you started with).I hope this is understandable ... maybe for those who find it hard to follow draw yourself some distributions or put some numbers on a spreadsheet but be sure to create enough scenarios across the range of all outcomes - then you'll see what I mean.Cheers - C.
Hi SeanSee my other post. Part of my work is quant stuff so I'm really just trying to help. Most people are not very good at probabilities (me included) and whether a psychological tool or not ... we just need to be clear on what's being done and why. If it's a tool like that then it should be stated as such. It hasn't really been. I'm not trying to accuse anyone of ill intentions here and I'm not trying to show up the Fool for being wrong (in their stock selection or in their math).I simply think that with the information provided I can back out what assessments were made and I can point to why those assessment were inconsistent/imprudent/whatever you want to call them.To your points:- It's not so much opacity as that it may give little value beyond the psychological ('moving the needle')- No issue with small/micro caps, I have both long and short positions in them (though heavily long based on MF, the shorts are 'gambles' on stuff I read on the internet and consequently very small).I don't believe the 'moving the needle' question is one of personal risk preference as such. It's simply that one needs to understand what one gets into - it has been advocated to label these 'ultra high risk' - presumably this implies for many that they would take a very small position. Nothing wrong with this, but we should all be clear that - in a basket, or the portfolio overall, it also means that we may get a psychological kick out of an 'xx bagger' but we won't have ended up with much of a return overall. That's all.I think where I am also critical in this area is that I believe for all the value MF adds, it is a marketing machine that misrepresents performance to the outside world. Say YONG does 500% over the next 3 years. I am virtually willing to bet my hat that there'll be an email after that advertising the services that had YONG very loudly, irrespective of the fact that for most subscribers that weighted it according to risk it would've been 500% standalone, but maybe 500%*0.01 in the portfolio. It's very selective advertisement that I abhor. Now I can't do anything about that, but at least I can help both advisors and members to think through what's implied in their assumptions and choices, which by human nature, they will not always have done themselves. Cheers C.
I seem to be given to long-winded explanations. I've just dug around in an old University textbook of mine and came across the following passage, which maybe makes one of the key points I'm trying get across better than I can:"Why frequencies matterNow let us return to the question of why probability judgments - and the beliefs they express - should be influenced by relative frequencies: That is, just what is wrong with believing that a randomly selected smoker's chance of getting lung cancer is .01 when 200 out of the last 1000 smokers have gotten lung cancer? [..] The personalist's answer is that indeed it is impossible to criticize a person for any honest blieve, as long as it is consistent with his other believes. The more information there is about relative frequency, however, in general, the closer the person's belief must come to what that information says. This is a result of the requirement of coherence itself. " (emphasis mine)I can highly recommend the book for those interested in thinking about their thinking in some depth: "Thinking and deciding" by Jonathan Baron. You do not need a mathematical background for it and it will definitely help you become better at thinking rationally and coherently.Cheers - C.
NoFate,Can you make your assertions more concrete/specific as it applies to YONG and Chinese microcaps generally? What do you think the outcome distribution is for YONG in 5 years? And what is the percentage of Chinese frauds listed on the 3 major US markets?I think that we both intuit significantly different values here...-Sean
Hi SeanFirst of all - this is NOT about YONG, which is why I moved the discussion into this board. This is about the general method for constructing, or general principles behind choosing to construct, a basket of stocks in an effort to attain desired risk/return profile.What my distribution of scenarios (= combination of outcome and probability) is vs. yours, vs. Tim's vs. Mr. X.' will of course be very different.The points I am making above are fairly general:1. If you start with selecting stocks from a Group that as a whole is much higher risk, you would be inconsistent in your probability assessment (across all scenarios) if you assume that your stock picking ability moves them to a risk profile that is much lower. The risk you should attribute to the individual stock should be higher than your average because the prior information you have indicates it is much higher. This is essentially a Bayesian argument.2. Given that the basket was constructed with a lot of weight on these stocks, it appears to me that, unfortunately, this is not what happened - i.e. the prior information (all these stocks have very high risk) was inadequately combined with the data (=stock information, familiarity, etc.) to yield a set of outcome/probability combinations that placed too much probability on positive outcomes and too little on negative ones given the prior information. This comes from Tim's figures and is what I spent so many words on in the previous posts (talking about where his probability mass seems to sit).3. If you construct a basket with these types of stocks it seems to me you have two choices - emphasise the 'risky' one and weight it out with less risky things OR emphasise the less risky and treat the more risky as a kind of kicker. Playing around with numbers it appears to me that either of these will work the way you want it to if, and only if, the range of outcomes of the one 'thing' (here by definition the risky stock(s)) is not too wide in the context of your assessment. (By that last bit I mean that of course any stock can go to -100% but we generally assign very little probability to that and so end up effectively combining things that we assume may vary from, say, -10% to +15%.)To your questions - around Chinese microcaps - quite frankly, I do not know and anything here would be subjective. However, consider that:(a) two years ago one may reasonably said that it's probably a higher proportion than for the same market in the US (=prior information)(b) over the last two years the prominent cases would have probably lead one to modify the prior upwards (= data)(c) as a result you'd have to assume that you're dealing with a class of entities with a higher risk profile if you were to construct a basket now.Hope that makes things clearer ... again, forget YONG, what I'm talking about principally is that only if the market had done well for the Chinese microcaps in the basket would it have performed in the way it was intended. In pretty much all other scenarios it does what it's meant to do ... sub-optimally (?) ... that's probably a good way too describe it (in a non-technical sense).Cheers - C.
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