Different Strokes For Different Folks: Discussing Risk & Reward

Playing To Win Vs. Playing Not To Lose: My Approach To Investments & Why I Have A Different Approach To Managed Accounts

Wall Street Giants

The thing that makes investing and markets difficult is that every market participant has different motivations, different strategies, and different time horizons. The large financial institutions like BlackRock and Vanguard are like the mindless giants that run ETFs and mutual funds. You buy shares of SPY 0.00%↑ or VOO 0.00%↑, the machine takes that and buys the S&P 500. If you sell shares, the machine sells the S&P 500. No fundamental analysis, no macroeconomic analysis, no comparison to other investment alternatives. You can see how this might be problematic, yet many investors have their 401k set to automatically buy the S&P 500 with every paycheck.

Other financial institutions use algorithms or high-frequency trading to skim pennies off the top, often using payment for order flow to front run other investors. Citadel (a market maker and hedge fund rolled into one) is one example of a company that has huge influence over American financial markets. Hedge funds run a variety of strategies, and they often charge 2% of Assets Under Management (AUM) and a 20% performance fee, many times for mediocre performance. They often focus on short term performance (often weekly and monthly), which can be a drag on long-term returns.

Where Are The Customer’s Yachts?

One hedge fund manager that I do listen to is Harris Kupperman, who runs Praetorian Capital. He is also a uranium bull, and owns a piece of offshore companies like Tidewater TDW 0.00%↑ and Valaris VAL 0.00%↑. I’m paraphrasing here, but his goal is to generate the best returns on a rolling three year period. If you want an example of what outperformance from a hedge fund would look like, go look up his performance since 2019. His performance justifies a higher fee structure, but most hedge funds don’t in my opinion. I am naturally skeptical of Wall Street and the surrounding group of financial institutions, because what they are best at is transferring money from a client’s pocket to their own pocket. One of the books on the reading list that I will get around to sooner or later is Where Are The Customer’s Yachts?. The short discussion is that Wall Street gets rich while the customers lose money, and for most people dealing with Wall Street, that is the case today.

My advantage against large financial institutions is patience and a long time horizon of three years or more, and the willingness to buy what is unpopular. I have heard it called the cocktail party test. In the late 90s, people were bragging about the dotcom stocks they owned. Today, if investments come up in the conversation, I think most would talk about owning Tesla TSLA 0.00%↑, Apple AAPL 0.00%↑, or Nvidia NVDA 0.00%↑. Basically whatever is hot at the time. A couple years ago I’m sure some of you remember GameStop GME 0.00%↑ and AMC AMC 0.00%↑ going parabolic in a short squeeze. If you are actually looking to outperform markets, you want own the stuff that people think is absolutely insane, but has a brighter future than most people think.

If I tell people that I own South American oil producers like Petrobras PBR 0.00%↑, Ecopetrol EC 0.00%↑, and I diversify that with coal companies like Peabody Energy BTU 0.00%↑, offshore drillers like Transocean RIG 0.00%↑ and Tidewater, and I throw in an office REIT like Vornado VNO 0.00%↑ and a cannabis REIT for good measure, they usually look at me like I have three heads. I fully understand that my strategy wouldn’t work for most investors, but I think that individual investors should adjust their strategy based on their age, risk tolerance, and knowledge.

Playing To Win

I’m a young investor in my twenties, I have no problem taking risks, and I like to think I know a lot about investments and the financial world. Yes, yes, pride comes before the fall, and I completely understand the risks that come with making large concentrated bets, but I think there are several opportunities out there that just don’t come along very often. If you want to be the investor that is buying when something is out of favor, it requires the ability (and the ego) to say that the market is wrong, I think that a certain stock is far too cheap, and the willingness to risk some amount of money on that bet.

I think there is enough evidence that says that the next several years are going to look a lot different than recent history in financial markets, and it’s going to be a good time to own commodities, real assets, and the related businesses. To me it looks like energy is a fat pitch and I’m positioned accordingly. I like to call it playing to win: I’m not where I want to be financially, but if things play out like I think they will, I will be well on my way to financial independence. The short version is that playing to win is playing to get rich.

Playing Not To Lose

On the other end of the risk spectrum, we have the investors that are playing not to lose. These investors already made their fortune, whether its from a business, a long history of saving, or are boomers that have ridden the real estate wave for decades. Instead of trying to grow their assets, they are trying to stay rich. Investors in this position decades ago could load up on bonds, and they would have been able to ride deflation and declining interest rates for years with very little risk. Now, it’s harder for investors in this situation to decide where to put money.

I think it would make sense to diversify. Whether that means 20% cash/bonds, 20% stocks, 20% commodities, 20% real estate, and 20% precious metals (gold/silver), or some other asset mix that significantly reduces risk is up to each investor. While 60% stocks and 40% bonds was the standard formula in the past, I think inflation makes that an unappealing option for investors.

I talked about this topic a bit in a past post, but I think investors ignoring the potential for inflation being higher for longer could be shooting themselves in the foot. If you don’t have commodities, real estate, or another asset that will handle inflation better than stocks and especially bonds, the 20s could be set up to be a lost decade.

A Lesson From My Recent Drawdown

This post was spurred by a recent discussion I had with friends, but I wanted to talk about a drawdown I had earlier this year and the bounce back that followed. It would be great if investing was a straight ride up and to the right. That is almost never the case with investing, and it definitely hasn’t been that way investing in commodities. I had a 6 week drawdown that was a 25% hit. Quick and painful, but I was convinced that I was right. Plenty of studies show that investors often sell bottoms and buy tops, and I had conviction that the stocks I owned were very cheap, and that the downturn was temporary.

Since the bottom, I’m up more than 70% and that certainly feels better than a large drawdown. I’m still very optimistic on my holdings because the valuations are still cheap. We will see how things play out, but commodities and the related stocks often have violent swings in both directions. If you look at the returns from the point before the drawdown to today, I’m up about 30%. It would certainly be less stressful to have those returns in a straight line, but that’s not how financial markets work. They say that volatility is the price of admission to the stock market.

Different Strokes For Different Folks

I recently got a question along the lines of “Why would you run someone else’s account differently from your own?” The basic premise is that I run my account with the goal of creating the best risk adjusted returns. Sometimes that means taking on more risk than others would be comfortable with, or buying stocks that others would avoid, and having a concentrated portfolio. Why wouldn’t I do the same for clients?

There are several reasons for it. If I lose my own money, there is no one to blame but myself. I’m in the driver’s seat and I’m responsible for every financial decision I make. If I lose money for someone else, I’m also the responsible party. It’s my decision, and that loss represents a combination of someone else’s time, hard work, and their past investments. That’s why I won’t use leverage on other people’s accounts, and I won’t be as concentrated in their portfolio.

Risk & Reward

Every investor has to decide how they want to approach investing. Some want to invest in the S&P 500 and set it and forget it. It’s a low effort approach that has worked for a long time, but nothing works forever in financial markets. Others want to speculate in the options market, or with day trading, or buying high risk stocks like junior gold miners. Much higher risk, but much higher reward. I’m closer to this end of the spectrum, but I think investors can dramatically reduce their risk by factoring in valuations and macroeconomics. I like to think of it as more of a calculated risk taking approach.

Your situation might be different than mine, and a variety of factors will impact your approach. Someone that is 3 years from retirement or has a large family will certainly have a lower risk tolerance. That’s not a bad or a good thing, it just is what it is. Eventually I will switch to the playing not to lose side of things, but hopefully not anytime soon. A single man in his twenties can play to win and take more chances. It will probably be a volatile ride, but that’s a risk I’m willing to take for what I think could be a large potential reward. If I’m not going to swing for the fences on some of these opportunities now, then when?

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Disclaimer

You should do your own research before making any investment decisions. Different investment strategies have different risk/return profiles which should be considered before making any decisions.

I would love to hear your opinions/thoughts in the comments below. Let me know what you think.