10-K Diver @10kdiver:
1/
Get a cup of coffee.
In this thread, I'll walk you through the key elements of a Cockroach Portfolio.
As investors, we want our portfolios to produce reasonable returns without major drawdowns.
Here are some key concepts to help you *construct* such portfolios: 👇
10-K Diver @10kdiver:
2/
Imagine we have a company: ABC, Inc.
ABC's stock trades on the NASDAQ (ticker: $ABC).
Most years, this stock grows 10%, reflecting growing revenues and profits at the company.
But from time to time (say, once every 10 years), there's a big drawdown. The stock crashes 50%.
10-K Diver @10kdiver:
3/
Of course, there's no way to predict in advance *when* such drawdowns will occur.
So, in any one year, the stock's return is essentially a "random variable" independent of all previous years -- with:
90% chance of a +10% return, and
10% chance of a *negative* 50% return.
10-K Diver @10kdiver:
4/
Suppose we buy and hold $ABC stock for 10 years.
What's our most likely return (CAGR) during this period?
Well, the most likely scenario is: 9 "up" years and 1 "down" year.
The "up" years each get us +10%.
BUT the "down" year brings our overall CAGR down to just +1.66%.
10-K Diver @10kdiver:
5/
Over 10 years, a ~1.66%/yr CAGR is pretty anemic.
But it's NOT unrealistic.
"Lost decades" are very much a feature of stock markets.
For example, from ~2000 to ~2010, the S&P 500 returned close to nothing.
As investors, we should prepare ourselves for such outcomes.
10-K Diver @10kdiver:
6/
Thus, big drawdowns can lead to lost decades.
So, how do we *avoid* such big drawdowns? Or at least, reduce their impact on our portfolio?
One approach is to hold a fraction of our portfolio in cash -- and re-balance our portfolio regularly between stocks and cash.
10-K Diver @10kdiver:
7/
This way, when we have good years and our stocks rise, we pull some money *out* of stocks and *add* to our cash pile.
And when there's a big drawdown, we use part of this cash pile to pick up some stocks on the cheap.
Over the long haul, this can help improve our returns.
10-K Diver @10kdiver:
8/
So, what's the optimal amount of cash to hold in our portfolio? 10% of the portfolio? 20%? 30%?
If we know the odds of a drawdown and how big it can be, the Kelly Criterion can help us figure out how much cash to keep.
For more: twitter.com/10kdiver/statu…
10-K Diver @10kdiver:
1) Get a cup of coffee.
In this thread, I'm going to walk you through "The Kelly Criterion".
10-K Diver @10kdiver:
9/
For example, our $ABC stock has a 10% chance of a 50% drawdown. And the other 90% of the time, the stock grows 10% per year.
Plugging these assumptions into the Kelly Criterion, we find that the *optimal* portfolio is 20% cash and 80% $ABC stock.
Calculations:
10-K Diver @10kdiver:
10/
So, when $ABC stock is 100% of our portfolio, our long-run CAGR is ~1.66%.
How much does this CAGR increase if we follow the Kelly Criterion -- ie, 80% $ABC stock, 20% cash, and annual re-balancing to stay that way?
Well, this improves our CAGR from ~1.66% to ~1.83%.
10-K Diver @10kdiver:
11/
All that fancy math and effort -- for a measly 0.17%.
Where's the justice in this universe?
And furthermore, Kelly tells us that this portfolio is *optimal*.
So, NO other "cash + $ABC + re-balancing" portfolio can beat this ~1.83%/yr either.
10-K Diver @10kdiver:
12/
So, IF we want to escape the effect of a big drawdown, our portfolio cannot have just cash and $ABC stock in it.
We need a new asset.
And this asset can come from a rather unlikely place.
10-K Diver @10kdiver:
13/
Suppose we have a second stock, $XYZ.
Unlike $ABC (which goes *up* most years), $XYZ goes *down* most years. And not by a small amount either -- but by 25%.
*Occasionally* though (about once in 10 years), $XYZ does super well. It 10-Xs -- ie, goes up +900%.
10-K Diver @10kdiver:
14/
$XYZ, it turns out, is a much *worse* stock to buy and hold than $ABC.
With $ABC, we at least get a *positive* return: ~1.66% per year.
But if we buy and hold $XYZ, we end up with a *negative* ~2.82% long-run CAGR.
One 10-X does NOT make up for nine 25% drops.
10-K Diver @10kdiver:
15/
So, over the long run, $XYZ LOSES money.
Why even bother with $XYZ then?
Because it has one redeeming feature: it's *negatively correlated* with $ABC.
Remember the 1 year out of 10 when $ABC experiences a 50% drawdown? That happens to be the year $XYZ 10-Xs.
10-K Diver @10kdiver:
16/
We can take advantage of this negative correlation.
How? We build a portfolio containing *both* $ABC and $XYZ.
9 out of 10 years, the $ABC part of the portfolio grows 10%. And the $XYZ part shrinks 25%.
When that happens, we sell some $ABC to buy *more* of the LOSER $XYZ.
10-K Diver @10kdiver:
17/
But 1 year out of 10, $ABC will experience a 50% drawdown.
That same year, $XYZ will 10-X.
And that's when we sell part of our $XYZ holdings to buy $ABC on the cheap.
Negative correlation + Re-balancing is a powerful combination.
10-K Diver @10kdiver:
18/
The Kelly Criterion again helps us work out the optimal split between $ABC and $XYZ.
It turns out to be: ~73.31% $ABC and ~26.69% $XYZ.
And this optimal portfolio achieves a ~12.41% per year long-run CAGR -- with NO drawdowns in ANY year!
10-K Diver @10kdiver:
19/
So, we have:
Just $ABC: ~1.66% CAGR, 50% drawdown,
Just $XYZ: *negative* ~2.82% CAGR, 25% drawdown,
$ABC + Cash: ~1.83% CAGR, 40% drawdown, and
$ABC + $XYZ: ~12.41% CAGR, NO drawdown.
That's the power of negative correlations and re-balancing.
10-K Diver @10kdiver:
20/
Of course, in the real world, stocks produce a range of returns -- not just +x% or -y%.
And the probabilities of these returns are not known so precisely.
And perfect negative correlations are hard to find.
So, our example wasn't super-realistic.
10-K Diver @10kdiver:
21/
Still, there are some broad lessons we can take away from this exercise.
First, we should look at investments from a "portfolio" perspective.
*Standalone*, a bet may have negative CAGR. But it may still add much value to a *portfolio* of other bets (eg, our $XYZ stock).
10-K Diver @10kdiver:
22/
Second, negatively correlations provide powerful diversification.
We can't usually predict the future.
But with negative correlations, we *can* construct our portfolio so that: no matter how the future plays out, there are almost always *some* bets that are paying off.
10-K Diver @10kdiver:
23/
The bets that are paying off provide liquidity and minimize portfolio level drawdowns.
This can give us opportunities to rotate out of them and re-balance into other assets on the cheap.
If we do this successfully, we can meaningfully improve our portfolio's performance.
10-K Diver @10kdiver:
24/
A financial advisor named Harry Browne popularized these ideas in the 1970s.
Browne suggested that investors construct their portfolios in a "future agnostic" way.
Whether the future brings growth or recession, inflation or deflation, the portfolio should still perform:
10-K Diver @10kdiver:
25/
Several well-known investors were inspired by Browne.
They developed Browne's ideas further and added their own unique spins.
For example, @RayDalio with his All Weather Portfolio, @MebFaber with his Trinity Portfolio, Mark Spitznagel with his Tail Hedging strategies, etc.
10-K Diver @10kdiver:
26/
My friend @TaylorPearsonMe and his colleague @JasonMutiny have also modeled their investment philosophy along similar lines.
Their approach is to generate negative correlations via "volatility" strategies (eg, VIX futures).
They call this the Cockroach Portfolio.
10-K Diver @10kdiver:
27/
These "negative correlation" techniques are super fun, and the core concepts behind them can be useful to investors of all stripes.
To learn more, please join @TaylorPearsonMe, @JasonMutiny, and me tomorrow (Sun, Mar 27) at 1pm ET on Money Concepts:
callin.com/link/JRNgYvcoDC
10-K Diver @10kdiver:
28/
About Money Concepts
We're a virtual investing club. Our goal is to help each other become better investors.
We meet Sundays at 1pm ET via @getcallin, to discuss all things investing.
Join us. Get the app. Subscribe. Tell your friends.
It's FREE.
callin.com/show/money-con…
10-K Diver @10kdiver:
29/
With wars going on, geopolitical tensions, fears about inflation, etc., it is super important to make our portfolios robust and resilient.
I hope the ideas in this thread gave you some insights into this.
Please stay safe. Enjoy your weekend!
/End