How I create a margin of safety in “risky” stock or option positions
Sometimes great ideas have a "risky" payoff structure. This is how I manage risk with this type of position.
I am seeing a number of opportunities in “riskier” stocks.
Before I write on this type of name, I figured that I would do a brief article (500 words) on how I manage risk with this type of position. A few of these could have explosive upside in 2023 as they potentially rebound from left-for-dead status.
For those attempting to beat the market, the most important element of an investment idea is to have an advantage with some reasonable level of probability.
It would be nice if every such idea offered a traditional margin of safety (low fundamental downside risk), yet this is not always the case.
For example, at times we uncover higher risk, or even binary outcome situations that still look extremely favorable (either you win a bunch, or lose most/all of the investment).
In my view, one of the greatest mistakes an investor can make is to over-invest in these high payoff, “call option” type situations - even if the expected value looks good.
Even with a strong advantage, too much risk will harm long-term return. With many such bets, risk or volatility of the entire portfolio can creep far higher than is intended, making extreme drawdowns possible - or likely, given time.
So how can investors capitalize on risky/binary opportunities, while still engineering some level of portfolio safety?
The answer is up to each investor - I can only tell you what I do.
My approach is to pair riskier, high payoff bets with cash/treasury bills.
For example, If I think an investment is favorable yet has greater downside risk/uncertainty, I might allocate 80% of my standard position size to cash, and only 20% to the risky position.
In a sense, I deleverage the risky bet.
My risk is capped at 20% of a standard position, while if the high payoff occurs, I can still make a substantial return on committed (the position plus cash) capital.
This approach can be very handy during a general market correction.
As risk in the “high risk” bucket is capped and matched with cash, I now have dry powder (uninvested cash) to rebalance and make trades.
On the other hand, if I am 100% invested with “margin of safety” stocks AND a smaller portion of aggressive bets, I would have nothing to work with - no dry powder.
This is why in my personal account, I am not concerned with being fully invested.
In fact, in a few of my best performance years, I put the least amount of capital at risk.
How is that possible?
I used a portion of my capital for the key positions, while I moved a larger portion to cash to mitigate risk or drawdown in the event I was wrong.
My risk was capped, yet I had high confidence where I had risk. In many ways, this is an ideal situation.
To date, this approach has paid off. However, if in the future a concentrated bet like this fails, my downside is contained.
When the double whammy hits (a market correction plus my specific ideas fail) I am not only capped in initial risk, but I have dry powder to work with.
In other words - If I am correct, I get a nice win. If I am wrong, I stay in the game + maintain the opportunism created by holding “dry powder”.
Works for me.
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