PRIMER: How To Think About Portfolio Construction & Trading
I plan to write more Primers on the site like I was doing last year and in years prior - this will let me dive into topics of interest and there are already some categorized under the Primers tab at the top of the site now:
Bankroll Management: A Lesson from Soros & Druckenmiller
One, as a tool for those to read to help them with certain subjects as it relates to trading/investing and two so that I can point people to when the question on these topics come up. When you do this for as long as I have the thought process and internalization of this stuff becomes hard-wired so it’s hard to want to really talk about things that were learned in the past because you’re learning and developing new frameworks and/or researching new companies where my time is spent. So, this should be a good tool to brain dump my views on the many topics in this business and a good tool for subscribers to use.
Portfolio Management
That being said, I am going to start with the idea of Portfolio Managmeent and this idea that I taught 4 years ago called “3 Bucket Approach” - it’s a cheesy name but it’s an easy way to mentally think about wealth and money for any trader/investor regardless of your capital or where you are in your career/life. Some of the ideas are borrowed bits and pieces from things I’ve learned over the years but the majority are my views as it relates to the idea of Portfolio Management.
When you approach the world of Portfolio Management it’s important to have a defined plan of what it is you’re after and most just don’t because they have not thought about it or really just know where to even begin. You have to conceptualize what it is you want and then work from “the finish line backwards” to see how you get there.
That’s really the first lesson: start from the end and work back and then you can see what it is you should or should not be doing as far as strategy(ies) or products to trade and or avoid - this goes the same for the aspiring traders reading this. I know that it’s easy to just want to jump in and trade the markets but if you don’t work backwards then you’ll just end up wasting time (and years) chasing the wrong products/using the wrong strategies. We can all agree that in this era of social media that it’s easy to want to jump in and have a “easy to learn strategy” but that there is a lot more to it than just that.
There are a lot of ways to construct a portfolio and we’re going to explore some of that here but this approach is one of the most direct ways to start to build out a framework and thought process to iterate into your own views.
Thinking like a business:
Within the framework of portfolio management, there needs to be an assessment of what market cycle we’re in and then from there you can begin to build out strategy to build a portfolio around that. You have to think of this as a business and understand what it is you want your business to be, what it takes to get there, the capital and time required etc. to come to a conclusion of what strategy set(s) to apply. For me, it’s not based on “trade setups” or back-tested systems it’s primarily driven around what market cycle we’re in then working the top-down investing approach from there.
This is why our long/short approach at the firm is based around a multi-strategy approach meaning we devise a strategy for any market cycle so that we can generate alpha. I don’t think that’s a widely accepted view from traditional investors/advisors if I’m being honest in my assessment, but, it does exist, just usually within the hedge fund space at the higher levels.
SmartAsset: What are Multi Strategy Hedge Funds
But, let’s keep this at a DIY level to start in this post because it’s better explained from that perspective (unless you’re reading this and run a HF in which case not sure why you’re here!)
Before I get into these graphics and this idea of 3 Buckets it is not our view that we use at our firm - it’s more like the graphic you see above. This is an approach that I have used for my personal portfolios and discussed years ago with many of you.
I am going to talk about the third bucket which are Core Holds in the paid section but let’s start with these.
This may not be an out-of-the-box approach and it should never be, you have to make (and also be willing) to make iterations to this to fit your views. The entire process of developing a system, thought process and portfolio is extremely iterative and it’s easy to get hung up on minute details so starting from a “simple” approach is usually best even if that means starting with smaller amounts of capital.
I don’t believe in using just one strategy. This is a thought process that the amateur trader/diy investor believes in their first few years; that there is one strategy that saves them. We trade cross-asset class, with various strategies, both long and short all changing based on the market cycle and and asset class we’re trading.
The goal is to think like a business where you run a research laboratory. Thinking like this is incredibly important because survival in financial markets is dependent on being able to adapt and survive changes in market regimes. Getting creative and thinking outside of the box helps, this is how I try to think.
You’ll see most that are new to markets (generally speaking) migrate toward three approaches:
Day trading low float stocks
Day trading futures
Day trading options
They tend to leave out the rest of the financial ecosystem because they are drawn toward the idea of action and fast profits. I only say this because I spent years around newer traders that thought like this and like an addict, you can only say so much - it’s ultimately their decision to make to change.
As a quick example - the ES or Nasdaq trader can easily iterate their understanding of orderflow/charts to express a long/short view through SPY/QQQ options structures but they usually don’t - they are obsessed with the fast move and instead miss a $300 point leg up/down (as an example) when all they needed to do was just structure a trade to capture that.
I look at the ES/Nasdaq futures and really only care (anymore) if there’s a larger 2-5% move coming and if I see it think of that situation as “How to I best structure that thesis to make the most money” - I don’t see that (though I used to as a prop trader back in 09/10) as what level is the level to trade from and I hope I can hold the trade and not get shaken out.
Another example of iterating and thinking creatively is looking at how say someone like Bill Ackman views markets. Whether you like him or not if you just look at some of his views he has been able to not only make investments on turnarounds like General Growth Properties but also but also a $2.6B CDS trade that was made.
The point is, there are ways to structure a portfolio if you can iterate and get creative and that’s what I am going to expand on in this primer.
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