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Subject:  Re: Risk-Adjusted Returns: Relevant? Date:  2/22/2002  2:26 PM
Author:  TWA40 Number:  176 of 297

I think you can approach this issue in 2 basic ways:

1) the "EMH/MPT" approach

2) the "EMH/MPT is BS" approach

If you take the EMH/MPT approach you essentially diversify away a lot of separate risks, which can perhaps now be lumped together as "company- or sector-specific risks". You do this by holding > 30 "random independent" companies, and your portfolio is basically going to move in concert with the underlying universe from which those companies were drawn (e.g. S&P 500, Wilshire 5000, etc.). Based on historical returns of equities, bonds, and cash, you can add in an appropriate weighting of bonds and cash to dampen the maximum potential loss that you're psychologically prepared to take in any given month, quarter, year, decade, etc.

You have basically accepted mediocrity, less friction. And I agree with Bogle that you should probably focus on minimizing frictional costs, because there's not much else you can do to boost returns.

If I was going to take this approach (and I'll have to soon, when I start a 401-k), I'd use Vanguard Funds or other exchange-traded funds to minimize MERs and I'd have minimal turnover, but I'd probably take a contrarian approach (e.g. tactical asset allocation) with new contributions. I wouldn't dollar-cost average into bonds or stocks, I'd purchase money market funds instead and then make tactical purchases of stock index funds or bond funds when prices were low relative to recent trends (i.e. breaking the lower Bollinger band, as based on weekly prices).

With the "EMH/MPT is BS" approach, which I utilize nearly exclusively, you rely on sufficient though not excessive diversification. For me, this means surviving a company specific blow-up like Enron or USG with a tolerable level of capital impairment. Being long 10 companies is a typical level of diversification for me, but it can be as many as 20 at times. And I could tolerate as few as 6, and would probably be a better investor if I did, but I get bored too easily.

There are very few mutual funds that practice this type of investing, and fewer that do it well, but Third Avenue Value (TAVFX) and Longleaf Partners come to mind in the U.S., or ABC Value in Canada where I'm from.

Adopting this approach means that you have to have a certain immunity to "pricing risk", the risk that other investors will continue to mis-price an equity. If I believed TKIOY was undervalued when I bought it at $36, I ought to believe it's even more undervalued when it sinks below $32. When I'm way underwater on a position, I'll begin to think in terms of "there's an increasing probability that others know something I don't know", but I generally don't react to price risk per se (for example, as you'd have to do if you were carrying positions on margin).

I don't pay any attention to beta, or implied volatility, other than to recognize it for what it is--the market's recent and future expectation for a given stock. If I think volatility is high, I might try to sell it with a covered option. If I think volatility is too low, I might structure a position with options instead of with shares. But it doesn't ever change my underlying opinion about the desirability of equity ownership in the underlying company.

I'm usually always hedged with 4-6 short positions. This isn't because of a conscious effort to be beta-neutral, although I certainly feel better knowing that a 300 point smack-down in the S&P probably isn't going to affect my portfolio by more than 5%. I enter into short positions for the same reason I enter into long positions, because I expect to make money on them. But rather than thinking I'm the great contrarian, I make a conscious effort at times to imagine I'm just another lemming.

You know, in trying to explain what I do, I get the uncomfortable feeling that I sound a lot like one of those blokes going up the escalator, but down the chute. But I don't think so. I'm drawn by another quote of Taleb's: "The best hedges are those you are the only one to put on."

Man, I'd sure win an Oscar for that one.

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