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Author: NoFate One star, 50 posts Old School Fool Global Fool Motley Fool One Everlasting Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 151  
Subject: Re: Basket cases? Date: 5/10/2011 2:18 PM
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Hi Tim

Ok - 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.
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