One secondary theme in the last couple of weeks has been the extent to which certain well regarded hedge fund managers have had very poor returns, surprisingly poor. The loudest of these has probably been John Paulsen with some reports having him down 47% YTD. I also recall reading that Whitney Tilson was down in the mid 20s but while I could not find that when I searched I did find this quote from him that “nobody lost more money or feels worse about our fund’s performance over the past year than we do.” Also the Tilson Focus Fund (TILFX) is down 23% YTD. We’ve also talked at great length about Bill Miller in this context.
In all cases there have been large bets on financial stocks along the way and of course it turned out that the financial crisis, as manifested in stock prices had not ended (and still hasn’t) when they put these positions on. There is not much utility in saying someone shouldn’t have done something because aside from the fact that it is too late, they did it, they would be lauded as having “done it again” if these trades worked and whatever the size of the bets, they might be smaller than the bets they made in the past that worked–meaning they have have dialed down the risk but it still didn’t work out.
The more useful thing to take from this for investors with more modest goals (like just having enough when you need it) could be to understand what will happen to your portfolio if some number of your assumptions are wrong. Assuming a portfolio goes narrower than some combo of SPY/EFA/IWM then there are assumptions built in to the portfolio. Looking out over 12, 24 or even 60 months we might each pick several of our holdings to be likely candidates to be the best performers. It is not very likely that the ones we think will be the top performers will actually turn out that way.
The best example of this I can think of is our purchase of Advanced Auto Parts (AAP) early in 2005. The thematic reason to buy it is pretty obvious and the company seemed like it was sound and it ended up far exceeding my expectations. This is an argument for owning more than just your favorite holdings.
In just owning ten favorites, for example, or concentrating on just several areas the consequences for being wrong are magnified. Add on top of that the consequence that can go with using leverage as appears to have been the case with Paulson. If you need to put 30% into bank stocks because you think they can’t go down anymore then you have to realize that is a big bet. BAC is down 50% YTD, GS is down 41% and C is down 38%. No one made big long bets on these names expecting those results but that is what happened and based on the results of the funds there appears to have been no mitigation for being wrong. It doesn’t matter if you use a price drop as a trigger to sell or not own so much that being wrong and holding on seriously or permanently impairs your capital (James Montier refers permanent impairing of capital on a regular basis).
This is why when I overweight or underweight a sector I only do so by a few percentage points, why I don’t put 15% into any single foreign country and why individual stock positions are usually targeted at 2-3% of the portfolio.
Part of the psychology here is that we are all going to have things we get wrong, it is unavoidable and of course we can’t really know what macro thesis will be the one (or more than one) that we get wrong. You’re probably not going make a long macro bet on Mexico if you thought it was on the verge of imploding.
Worrying about being wrong is not the right way to go as opposed to worrying about the consequence of being wrong. If in a bad year, personally, you are flat in an up 10% world or down 10% in a flat world is not the type of thing that will necessitate a financial plan re-write. Something like Paulson’s down 47% in a down 5% world will.