Games

Concentration gets you rich. Diversification keeps you rich.

For most of us who are not career money managers (or skilled DIYers who might as well be), we are looking for a balance of these two concepts in our portfolios.

There is an ascetic strain of financial advice that abhors any kind of concentrated risk-taking. The world is a random and frightening place. It is difficult to distinguish skill from luck. Concentrated risk-taking is just gambling. Your returns will probably end up looking like the broad market averages over long periods of time, and you run the risk of significantly underperforming those averages. Why bother?

On the other hand, many people have earned vast fortunes through concentrated risk-taking. I don’t imagine they lose much sleep over whether their returns came from luck or skill. Likewise, most of us who spend time editorializing on portfolio construction have obtained our megaphones through some kind of concentrated equity or quasi-equity exposure. We either explicitly own a concentrated equity position in an advisory or asset management business, or have implicitly built a concentrated quasi-equity position in some kind of personal brand.

One of my first posts was about regret minimization as the organizing principle for financial decisions. Regret functions vary. Personal attitudes toward “get rich” versus “stay rich” portfolio construction necessarily vary as well. Overall, I suspect regret functions are relatively normally distributed. There is a thin left tail of extremely fearful investors who abhor the idea of any kind of loss. There is a thin right tail of extremely aggressive investors who cannot stand the idea of forgoing gains. The rest of us fall in the body of the distribution. We don’t want to risk gambling our wealth away, but we’d like to own a few lottery tickets on the side.

I like to think about investing as a series of nested games. The ascetics are right to point out the difficulty many of us face distinguishing between positive expected value and negative expected value games. A positive expected value game that pretty much everyone can play with minimal effort is to shovel money into a diversified portfolio at regular intervals. This strategy has its failure modes (positive expected value =/= guaranteed return), but I believe this is “good enough” for most people who want to spend their time and energy on other pursuits.

Beyond that, the most straightforward +EV game to learn is probably “value investing” and its innumerable variations. In Fancy Terms, this is a short convexity strategy based on mean reversion (a.k.a dip buying). The basic strategy is simplicity itself. Find an asset you believe has suffered a temporary price dislocation for whatever reason, and buy it conditional on some expected return hurdle. You can make a lot of money doing this, though you have to be mindful of additional failure modes compared to the diversified strategy. Chief among these is the “value trap”: the asset that is not merely “cheap” but “cheap for a reason” and does not mean revert. Archetypical, vanilla value investing deliberately disregards market feedback. Smart value strategies develop guardrails to help mitigate this failure mode.

B-b-buh Buffett… some might respond.

LOL. Buffett changes his mind all the time.

There is a subtle difference between what I describe as value investing above and what I would describe as growth investing. My definition of growth investing is different from the widely used style-based concept, which is just the mean-reverting value investing strategy applied to higher growth, more optically expensive stocks. My definition of a growth strategy is a strategy that is long convexity, with a return profile that looks like a call option. The archetypical example is venture capital, though I would also include other long duration, “permanent capital” types of equity strategies under this umbrella.

We could get into games like trend/momentum and some of the more esoteric stuff that goes on in options land. But this post is already running long and, more importantly, I may want to grift off this taxonomy some day. What I am hinting at is a more systematic way of thinking about whether/how to go about concentrated risk-taking.

What is the game I’m playing? (the real game, not the cartoon version people talk about on the internet)

Why is this is a positive expected value game?

Do I have the time and resources to learn this game and play it well?

Who are the donkeys in this game? (remember, when you are learning, you are one of the donkeys)

Do the skills and mindset needed to play this game well match my own skills and temperament? If not, can I develop the necessary skills and mindset? Am I willing to put in the work?

(with some slight modifications you can easily extend this to “real world” risk-taking such as entrepreneurship)

If your reaction to this is “no” or “this is stupid LOL I just want to gamble on stonks” then I would suggest smaller position sizing in your games of choice. Or, consider delegating some of the day-to-day game-playing to a professional who specializes in that type of game.

There is a whole elegant investment manager selection and evaluation framework to be built out here. But in deference to future grifting, I’m not going to get into that here.