How to Lose $5 Million in 30 Days
I wish my story about how to lose $5 million in 30 days involved being in Vegas with a lot of hookers and blow. I really do, because I could at least say that I had a great time while losing money. And it would make a great movie. Unfortunately, my story is much more mundane. But it does highlight the importance of managing risk and diversification, so at least it was a learning experience. And that if you’re going to lose a lot of money, do it having fun instead.
I would like to point out that I’ve consistently made money on the buy side. Even with this loss, I was still up for the year. Investors get really sensitive when it comes to making money. Make fun of how I look or call me an a**hole? I’m used to it and you probably have a point. Insult my family? You’re pushing it. Say that I don’t make money? Whoa, you’ve crossed so many lines and now we need to duel.
Losing $5mn in a month may not be much for some investors, but remember that I invest using a market neutral strategy. I don’t take much risk and hedge most of my bets, so my returns should not move much on a daily basis. Based on my risk parameters, this was a lot of money. And it all started with Trump.
What I Got Wrong
1. I Didn’t Think Trump Would Win
I didn’t anticipate Trump becoming President. Not many people on Wall St. did. Polls were showing Clinton with a comfortable lead, so most investors were expecting another four years with a Democratic White House. Of course, it’s easy to say now that the polls were wrong, but my job is look at probabilities and all the data was pointing to a Clinton win.
2 I Didn’t Expect a Positive Reaction After the Win
When Trump was declared the winner, the immediate reaction in the markets was negative. The Dow was down 1.5% pre-market. Investors hate uncertainty. And here was the most uncertain President in a long time. He wasn’t a politician. He wasn’t politically correct. There was a lot of uncertainty around many of his policies. And some of the ones he was clear on weren’t business friendly. But something changed overnight. Investors suddenly realized that for the first time in 8 years, we’d have a Republican President. One that would reduce regulation and cut taxes. And that there’d be nothing stopping him because Republicans controlled the House and Senate.
I was skeptical of this because it has been tried before. President Bush tried to push ahead of tax reform and failed, even with Republicans controlling the House and Senate for most of his term. The problem with tax reform is that there are winners and there are losers. And the losers will fight tooth and nail make sure nothing changes.
I’m still a novice when it comes to politics, but one thing I’ve learned is that the only thing Washington is good at is gridlock. This can be good because if nothing gets done, you get the status quo, which is what investors like.
But I was told this time it’s going to be different (famous last words). When a narrative takes hold on Wall St., especially one that brings hope, good luck stopping it.
3. I Wasn’t as Hedged as I Thought
Remember when I said that I’m hedged? Well, I wasn’t as hedged as much as I thought. A lot of narratives came out from the Trump win. First, we would see a reduction in US corporate tax rates. Who benefits from this the most? Companies that get most of their revenue in the US, and those that pay the highest tax rates. I wasn’t hedged for this.
When I think about hedging, I look at geographic exposure, market caps and end-market exposure. I never hedge for tax rates. Hedging for tax was completely new to me because even if two companies had 100% of their revenue in the US, the one with a lower tax rate, either driven by NOLs (net operating losses) or TRAs (tax receivable agreements), would see the value of their tax shields decline.
Second, interest rates shot up on expectations for an improving economy. I didn’t have exposure to banks, but I did have exposure to financials companies. I got hit because of a rotation (see fund flows). See, many financials investors were underweight banks. Because banks benefit from rising rates, investors started selling other financials to buy bank stocks. I was not hedged for this rotation.
Think Hard About Portfolio Construction
Experts always talk about diversifying your portfolio to hedge against company-specific risk. In my personal account, I try to hold 15–20 names for sufficient diversification. But diversification isn’t just about having a lot of names. Owning 20 banks doesn’t really make you that diversified.
To really think about diversification, you need to think hard about the end markets your stocks are in, along with their geographic exposures. On top of that, consider how your stocks trade in different types of economic cycles and market environments. Are they cyclical, early cycle, or late cycle? Are your stocks growth oriented, value driven, or defensive? To truly have a diversified portfolio, you don’t want to over-index to one specific type of stock. I wasn’t properly diversified, but hopefully you will be when another major event happens.
Originally published at www.marginofsaving.com on July 23, 2017.
