[VSG Premium] Reworking the Position Sizing and Portfolio Risk Management Processes

Over the last few months I have been working on a much formalized strategy to define position sizes and risk management in the portfolio. This new strategy borrows elements of downside risk protection from short term traders (the best of them win because they manage risks properly), as well as many ideas from the new concepts of factor based investing and possibly utilizing smart beta etfs.

I now have a very good idea of how this will work within our value investing paradigm. I will begin rolling out these new processes in our Value Stock Guide Premium portfolio and we may adjust it over time to fine tune.

Why am I doing this?

Value investing calls for discipline and commitment to the long term. Often this faith is tested over time for 2 reasons

1. Drawdowns (portfolio value decline from the peak) can be quite large at times
2. A necessary focus on small cap and less liquid stocks introduces a large amount of volatility in the portfolio

Furthermore, we tend to be exposed to cash for large stretches of time that costs us in opportunity. We hope that ready cash gives us options of quick purchases and this advantage can offset the opportunity cost of the cash. During time when value investing underperforms for long periods of time (such has been the case for 10 years now), the option value of the cash is not enough to offset the opportunity cost incurred in keeping the cash idle.

The new processes aim to address both the risk and the opportunity cost aspect in the portfolio.

Addressing Risk (Drawdowns and Volatility)

I am the first to say that volatility is not the same as risk. However, a drawdown is basically capital loss, however temporary, and is something that this risk management process will address. The way it does this is via tracking the short term volatility of the asset.

1. We calculate the ATR or Average True Range of each stock in the past 2 weeks. In short this number represents how much a stock tends to move each day on average.
2. We place stop loss orders at a reasonable level below the current price. This will limit the price declines in any one stock that we will be exposed to in the portfolio.
3. Since our value selections can be volatile, the goal is to pick the stop loss at a level that allows the stock to fluctuate in the normal course of regular market action. Therefore the stop loss levels will be quite a distance away from the current prices. This will help us protect from a large decline in the stock price, but will not interfere with a normal stock price movement and exit prematurely.
4. I am currently leaning towards a stop loss level that is 10ATR away from the current price. This allows us to map our stop exits to the volatility that is specific to the stock (instead of a flat % value)
5. On a monthly basis, I will adjust the stop loss value for each stock in the portfolio based on the current prices and new ATR values. The stop loss values will only move up if the stock price appreciates. If the stock price declines, there will be no change in the stop loss value from the previous level. This way, we aim to take the upside in the stock while we limit the downside.

If a stock declines and we get stopped out, we will continue to have the option of getting back in the stock once it has declined further and the value thesis remains.

6. The initial investment in any new stock will depend on the ATR values as well. The idea is to standardize the amount of capital we are risking in each position over time. We have instinctively done this in the past. More volatile positions get smaller allocation. This will now be more formalized.

Note to VSG Premium Members: Every new Premium recommendation from now onwards will include a suggestion for the initial stop loss order. I will be sending out stop loss levels for the existing positions via email soon.

Addressing the Opportunity Cost of Cash

 

In short this involves using uncorrelated assets to capture additional alpha while valuations in the market are high.

More details have been posted in the forum for Premium members.

To learn more about VSG Premium go here