With the World Cup coming up, I thought it was timely to share a mental model that I find helpful in constructing a portfolio. Don’t get me wrong, I am not trying to gamify investing. Far from it – I take my responsibility for our capital very seriously. However, I frequently find that other disciplines have a lot to offer in helping me think about how to best invest, and this is one of those times.
Q3 2022 hedge fund letters, conferences and more
Why are there no serious soccer teams with 11 goalies or 11 forwards? Perhaps an episode from my youngest son’s kindergarten soccer league provides a good illustration. One of the other teams was having a rough session. So the parent-coach had a bright idea – since his team was getting outplayed, he would have all 5 of his little players line up and block the goal. At least this way the other team won’t be able to score and his team wouldn’t lose.
The frustrated coach’s strategy did eliminate winning as a possibility. However, it didn’t prevent a loss. The “wall-o’-kids” worked for a while at blocking the shots. Eventually, one of the 5 year-olds moved the wrong way, and the opposing team’s shot got through.
Real soccer teams have some combination of forwards, midfielders, defenders and a goalie. The mix varies, but not a whole lot. The team has very different expectations from players in each position.
A goalie is (almost) never expected to score, but is responsible for preventing the opposing team from doing so.
Defenders are largely responsible for taking the ball away from the other team and distributing it to other players.
Midfielders are expected to contribute to both defense and offense.
Forwards are largely responsible for scoring, and have few defensive responsibilities, if any.
Individually, each position doesn’t provide enough to the team to enable a win, but a good coach can put together the right mix of players in the right positions to give the team a good chance at victory. Do circumstances affect the mix of players? Sure. Sometimes the roster suggests that there are not enough talented forwards, but plenty of talent among the midfielders. Other times, the score in the game or the composition of the opposing team might cause the coach to change up the mix of positions. But never in an extreme way.
Just like a soccer team needs to have a proper mix of positions to succeed, so does an investment portfolio. We don’t know how the future will unfold. Will there be a severe recession or none at all? Will the froth in the stock market over the last few years give way to despondent pessimism or to just mere calm rationality? So we need a portfolio that can do well in any environment, not one where we go all-in on a specific path the future might take. We can’t have 11 goalies or 11 forwards.
So what are the different “investing positions” in a portfolio?
The “goalie” in a portfolio guards against unusually bad developments. An example might be put options on an index which would pay off meaningfully if disaster strikes.
The “defenders” are investments will low, well-defined downside and moderate expected return. That downside protection can’t be just some valuation statistic – cheap stocks can always get cheaper.
The “midfielders” are investments with good expected return and moderate downside.
The “forwards” are those investments that have tremendous upside if they work out, but meaningful, even 100%, downside risk.
These building blocks should allow us to build an investment portfolio with desired risk and reward parameters. The “goalies” and the “defenders” are not expected to produce large returns. However, they allow us the confidence to have portions of the portfolio which can do just that.
It would be highly speculative and unwise to have a portfolio of all “forwards.” That wouldn’t meet our definition of investing, where the goal is both safety of principal and an attractive return. Having all “goalies” and “defenders” would just be market timing that would work well in one future path but not in the rest. It also wouldn’t provide us with the desired level of returns. The right combination of “investing positions” can allow us to have an appropriate balance between risk and reward across most paths the future can take.
Article by Behavioral Value Investor.
