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Author: trader2012 Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35357  
Subject: Re: Revising Howard’s Scanning Rule Date: 2/29/2012 4:56 PM
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Howard,

Instead of charging your bond-risks against just your bond portfolio, charge them against your whole portfolio. Risk is risk, no matter where it comes from, and if a position is too big, then it’s too big. Likewise, if it’s too small, then it’s too small, which is where most investor fail themselves by not taking on sufficient risk (for all of the well-studied reasons). But the net-result in either case is the same, a loss of nominal-principal due to price reversals, or a loss of purchasing-power due to inflation. Either one will kill a portfolio as surely as the other. One is just less obvious and, thus, less feared.

Suggestion: find Moody’s white paper on defaults and construct a default table for yourself. What you’ll find is that the rates approximate a Fibonacci series. Normalize it and then down-grade each rating one notch (i.e., increase its default-rate by the next number in the Fib series). That becomes the rule of thumb benchmark against which you do your buying. In other words, in the same way a Black Jack player can count cards and adjust his bet size, a junk bond buyer can attempt to do the same.

I say “attempt”, because there is never a statistically valid sample of any of the lower ratings for sale, nor will any but the largest of portfolios ever be able to hold a statistically-valid sample (whose size can be argued about, but, trust me, the responsible work in the field, not the MPT idiots, suggests the numbers are huge).

The workaround, obviously, is to attempt to achieve statistical validity diachronically. In other words, retrospectively, the buying will appear to have been less than optimal. OTOH, when the black swans fly, no more than a tolerable number will land in your pond. Taleb hammers on this stuff constantly, and that's how risk has to be managed and portfolios built, to survive the damage you know will happen, but about which you cannot know "How soon?" or "How much?" Therefore, the possibility of total failure has to be accepted and effectively hedged. But then, you know that. You just don't think you do.

Charlie
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