I want to take the time to discuss my investment philosophy in a bit more detail as I believe it will provide you, a potential partner, more clarity into the mindset of your potential money manager. I will break these investment philosophy pieces up into three different parts, with this first part being about losses.
You might be wondering why I am starting with losses, given the main goal of firms is to maximize profit. That is not the main goal of Rockvue Capital. The main goal is to minimize losses and restrict drawdowns as much as possible. By doing this, I am able to let the profits take care of themselves, while preserving my capital, and your capital. Let’s breakdown how I do this in Rockvue Capital. (The investment philosophy discussed herein these three parts have solely to do with the Voyager Fund. The SteadFast fund is algorithmic and independent of discretionary action from myself).
Using Stop – Losses To Mitigate Risk
The most important factor in mitigating risk and drawdowns in the Fund is through the power of stop – losses. Stop – losses for those that aren’t familiar, are used in trading to set a predetermined price at which one exits a trade. Using an example, let’s say I want to buy stock XYZ on a breakout at $5 on a symmetrical triangle pattern. Now, on this trade, I will place my stop – loss order on a price at which my bet would be wrong. In other words, I would place my stop – loss at a technical point that would signal me to get out. If this still doesn’t make sense, feel free to email me with any personal questions.
Here is the most important part about using stop – losses: I have yet to sustain an individual loss of greater than 1% per trade. This is very important to me, and it should have the utmost meaning to you as a potential partner. Through the power of stop – losses and moving those stop – losses up as soon as I can, I am able to lock in profits as soon as possible, and try to get to breakeven as soon as I can. This is what I am referring to when I talk about minimizing as much risk as possible. Now that you understand a little bit more about how I manage risk technically from stop – loss orders, I would like to take the remaining time of this memo to discuss my views on losing in the markets.
How I (And You) Should Handle Losses
My view on losses may come as surprising to those who haven’t read my work before, or frankly who are reading this memo and haven’t read previous memos. I will make a lot of losses. Statistically my losses will outnumber my wins, the scale of which I do not know specifically. So far, the ratio is close to 45% winning percentage. I am not worried about this. In fact, I would be completely comfortable with a 1% win rate if at the end of the year I am net profitable. I don’t believe this will ever happen, but the point I am making is that I am a firm believer in Pareto’s Principle.
Pareto’s Principle states that 80% of outcomes come from 20% of the inputs. If I can focus on the 20% profitable trades, I can sustain 80% of my success from 20% of those trades. The reason that I am comfortable with this principle is that the losses I sustain are very small compared to the size of the gains I receive on my profitable trades. I hope that you understand this principle as a potential partner in the Fund. If the idea of suffering lots of small losses is something that you are not comfortable with, I completely understand, but I would love to discuss it with you personally before making a decision to either invest or pull capital.
Positive Asymmetry in The Fund
As a caveat for my talk on losses, I want to end the memo with a word on positive asymmetry. The Fund will at all times have a positive asymmetric skew to the profile of its returns. This goes back to the Pareto Principle I discussed earlier. If you look at a Normal Distribution, you will see a symmetrical bell shaped curve along the various probability distributions. This is what the return distribution will probably look like at Rockvue Capital:
As you can see, the amount of small losses (as the x axis shifts towards the left) will outnumber my wins, which is what we should expect going forward. however, the power in asymmetry is that the smaller number of profitable trades will cover for the losses and (hopefully) return a net profit after commissions and expenses.
A Final Word
This first memo got a bit mathematical and technical, so I apologize if some of this material went over some heads, that was not the intention. When dealing with losses, it is important to get granular to understand the reasoning behind my philosophy on losses and the purpose of my stance to the firm.
Once again, all of what I do directly impacts your potential capital investment. For this reason, I want to be as transparent as possible with my philosophy. Stay tuned for Part 2 of the Philosophy Memos where I discuss the criteria on which I invest in equity positions.
I want to discuss part two of my Investment Philosophy series, Portfolio Concentration and Diversification. Although this is not the most important part of my philosophy (that was discussed in part 1), it is still very important for you as a potential investor in the Fund to understand how I think about such matters like diversification and the concentration of my portfolio.
If you are a reader of my investment blog, which is more or less an extension
of these letters I send to you, you might have picked up on the amount of holdings I may have at any given point in the Fund. I often say that I like to stick to roughly 8 – 12 positions at any given time. Now you may ask, ‘Why 8 – 12?’, and that is a great question. The honest answer is this: Anything above 8 – 12 I start to have a hard time really concentrating on each position and making the best decisions for each position. This is why, as your Fund Manager, you will never see the Fund hold 50 or 100 positions. To me this is both insane and stupid.
Ray Dalio, who is one of the most respected investors in the world, and CEO of the largest hedge fund in the world, wrote a great piece on diversification, and I would like to put a snippet of that piece in this letter. Here it is:
“All investment assets are priced to be exchanges of lump-sum payments for future cash flows; i.e., when assessing their value the market estimates the present values of those cash flows. And they all compete with each other, with investors trying to buy those that are cheap and sell those that are expensive. Because so many people put so much effort into doing this well, markets are generally pretty efficient—i.e., there aren’t many no-brainers that allow one to buy one thing and sell another to confidently make a favorable return spread. Trying to do that is trying to create alpha, which we do in our Pure Alpha accounts. In our All Weather account, we assume that we don’t know what investment assets will be better and worse than others, so we try to buy all sorts of stocks, bonds and commodities in the right proportions to produce good diversification.”
On this topic, it is known statistically that after 20 individual positions, the
diversification benefit from that additional position is nothing, zero. This means that a portfolio with 100 different positions is more or less equally diversified when compared to a portfolio with 20 positions. The key to this though is to find zero correlated bets. However, we live in a world where everything seems to be connected, so achieving a zero correlation bet is near impossible, but it is the benchmark to strive for. It is precisely for this reason that I don’t see the benefit of holding more than 20 positions at any given time.
The other reason I am not a huge believer in the classical diversification
methods is because I believe it can diminish returns by being too wide spread.
In other words, think about the diversification dichotomy in two ways via a
horse race betting story: 1) Rockvue Capital Diversification – Casting no more
than 8 – 12 bets on horses with the best risk reward ratios of payout, not the
horse with the greatest chance. 2) Traditional Diversification – Place equal
sized bets on every single horse in the race, guaranteeing you don’t lose
As you can see, the second option offers the best protection in terms of
downside risk. No matter what were to happen in the horse race, the bettor
would’ve broke even. However, this is a terrible investment strategy when
capital is being risked. Sadly, that is what so many individuals do. They go to a
financial advisor who then puts their capital into a broad range of mutual funds
and ETFs. The problem with that is a mutual fund is already supposed to be a
diversified investment. So, when you combine multiple mutual funds, you end
up owning the same thing in different places, thus actually increasing your risk
I believe that that is both a lazy and not fiduciarily responsible maneuver for
most advisors, and it is detrimental to partner capital. That is not Rockvue
Capital, and that will never be Rockvue Capital. We will never invest in any
mutual fund. Why would we when we believe our fund is better than the
Diversification Example in Voyager Fund
With all that being said, the portfolio current has 19 positions. Now I
know you might be thinking to yourself, “Why talk about diversification
and 8 – 12 position limits when you currently have almost double what
you recommend for the Fund? That is a great question. The answer is
quite simple: The increase in positions is due to a “basket” style trade
that I have experimented with over the last couple of months.
This “basket” trade is similar to buying an ETF of such industries or
theses, but with a basket of my own creation, I have much more control
over how I express my bullish thesis. Let’s take a look at a real – time example in the Voyager Fund.
When I did my long oil thesis, I wanted to
express it in a basket. I went long four equity positions: WTI, CVE, ESV,
and BTE. That basket of four equities I consider one large basket trade.
I hope this makes sense to you as a potential investor. This means that
those four trades I personally consider as one trade, and I advise you to
do the same.
Diversification is something that is important to me, but not too
important. Too much emphasis on diversification puts caps on returns.
With proper risk management and capital allocation, diversification is
more of an afterthought for the Fund. That being said, it is important to
construct a portfolio where each trade is as lowly correlated with one
another as possible. This goes for the “basket” trades as well. I do not
want two basket trades of the same thesis.
If the most important part of my trading strategy is capital risk management, patience is a close second. Patience is something that I personally struggle with in almost every aspect of my life besides the markets, which is weird to some degree, but a benefit to those who would one day choose to invest with me. I didn’t use to be that way of course, it took a lot of lessons learned and dollars lost before I understood the true benefits of patience in the markets. Throughout this piece I will highlight three reasons as to why patience is key when dealing in financial markets, and the pitfalls that traders and investors can stumble into if they do not adhere to patience.
Reason 1: Patience Saves Money
Patience in the markets saves the investor countless dollars, most of those dollars saved aren’t even from the potential loss of a rushed investment. The dollars I am talking about are commission dollars forked out with each trade. If one rushes to make trades, not waiting for ideal classical chart setups, the trader ends up in a precarious situation of paying a lot more in commissions at the end of the month than a patient trader.
When one enters a trade (unless using a free brokerage like Robinhood, which I advise against if you are a serious trader), they have to pay to buy (or sell) the stock, and then again once they exit their position. Thus, increased (or rushed) trades leads to increased expenses at the Fund, which in turn would lead to lower net returns for the Fund’s shareholders. It is for this reason that I make it poignant to never rush a trade, and to always be patient. The less commission costs I incur for the Fund, the greater the net returns will be for its shareholders.
Holding all else constant, I want to talk about the realized dollar losses of rushed trades. As an investor, it is my responsibility to enter a trade when and only when the trade has met my criteria for a proper trade. This will look different for every speculator in the markets, but my criteria for a proper trade is well documented within the interwebs of this investment blog. Every trade I make outside of those contingencies is a risky trade, a careless trade, and a trade most likely done on the basis of rushing myself. For this reason I keep a documented journal of all of my trades when I enter a trade, as well as when I exit a trade. I do this so I can judge how I was feeling, why I entered the trade, and what I expected from this trade. In doing so, I create transparency with myself and for anyone who wants to know the motives of my trades I will provide them at once. If you receive my newsletter emails, you already see a taste of this when I enter trades. If you are not on the newsletter, please comment to this post or email me at firstname.lastname@example.org.
2. Patience Saves Psyche
More than dollar capital saved, patience in the financial markets saves mental capital to an exponentially higher degree. I am all for saving and increasing my mental capital. I do this a) because I started this speculating game at a relatively young age of 13, and b) It is the only way I know to keep me level headed when looking at financial markets. Burnout is something that every financial market speculator must come to terms with. Burnout is the Darwinian model that separates the veterans from the newbies that exit the game as quickly as they entered. My goal is to be one of the greatest investors in North America (some of you might be thinking, ‘Why not just say the world?’, and to that I don’t have a credible response). In order to do this, I recognize the need to STAY IN THE GAME. Practicing patience in the financial markets saves my mental capital by allowing me to be on the sidelines if I don’t find anything really worth investing. The problem with a lot of institutional investors, and even novice traders is they think they have to always be in the market, to always be trading. On the institutional side of the coin, investors must show their clients that they are in the markets, even going so far as buying big names just so that their clients recognize names when they open their quarterly letters.
As an investor, I will never do this. I don’t like rules, except for the rules that I make for myself. It sounds very weird saying that, but it is true. I don’t like having investment rules placed on me that I can’t control. I make investment decisions based on what I think is undervalued and a great technical chart set-up, not whether or not Sally or Joe will recognize the names of the companies in the Portfolio. I don’t cater to any particular clients interests except for the interest of maximizing return and minimizing risk.
By being on the sidelines, I don’t have to add that extra stress of feeling like I need to be in the markets 24/7. One of my favorite investors to read and listen to is Seth Klarman. Klarman is one of the greatest deep value investors of all time, and his book on the Margin of Safety can be bought on eBay for $1,500. Seriously. What separates Klarman from the rest of the investors pack? Simply put, Klarman isn’t afraid to hold large cash balances, sometimes in excess of 50% of the total portfolio. That takes discipline and patience.
3. Patience Creates Flexibility
Piggybacking off of the second point, financial flexibility within the Fund is crucial and can only be done if the Investor has patience. If an investor doesn’t have patience, they will likely suffer from having their portfolio overexposed to various markets, very little cash balances, and rushed trades placed at inopportune technical targets. As a patient investor, holding appropriate cash balances when necessary, when an opportunity knocks you have the ability to jump on it fast. Plus, with the increased cash holdings the patient investor doesn’t necessarily need to liquidate any current positions for a foreseen better position.
To conclude, patience is a close second to risk and capital management when it comes to what makes an investor a great investor. Without patience, an investor can have a terrific strategy, a terrific ability to read technical charts, but will have nothing to show for it due to rushed trades and taking profits too quickly. As your fund manager, disciplined patience is what I will always strive for.