#Quora: How should I manage a client’s portfolio if he wants a 8-10% return and no negative years worse than -5%, and has a starting amount of $2…

How should I manage a client’s portfolio if he wants a 8-10% return and no negative years worse t… by Laurent Bernut

Answer by Laurent Bernut:

Experience has taught me that people like this are a plague. They are not risk adverse. They are conservative to the point of being risk seeking: by refusing to accept moderate waves of volatility, they invite left tails tsunami. If You cannot afford to turn his money away however, here are the formulas

A. Psychology of conservative people

If You can’t stand losing, then You shouldn’t play. When they say they are willing to accept modest returns as long as You don’t lose much, what they mean is they do not want to lose at all.

Conservative is not synonymous with risk adverse. They are opposite in fact. Risk adverse means You have articulated and quantified your risk appetite. Conservative means You are afraid of taking any risk. You are ready to discount your ambitions to the point they will be met with certainty. Kodak, Nokia were risk adverse…

It also means they are afraid and think everything is risky. It is your responsibility to educate them on risk. Do not step into dissertation mode about China, the Fed, Venusians landing in Central Park and Yoyogi park in Tokyo (i will sacrifice myself and volunteer if those sexy Venusians want to perform tests on my body). Risk is not a story, risk is a number.

Secondly, if You deliver, they are likely to demand more over time: 8–10% turns to 10–12% etc. Two reasons for this: you will be put in competition with other managers who promise they can deliver better with the same risk. Since your returns are underwhelming, You will be in constant competition. Secondly, and this is more insidious, they become overconfident. Since they believed everything was risky but now are making money, and they still don’t understand risk, they turn euphoric, literally drunk on testosterone and dopamine. They are laughing their way to the bank until the day you start losing again.

B. Market’s money

The strategy is to start small with minimum risk and increase gradually as you generate performance. Then, before year end, you reduce risk so as to start the new year afresh.

Many people do the gradual increase well, but forget about the decrease. Investors think in calendar years.

Example: first quarter, you generated 2%. You can now increase risk by x% of your gains (10–33%). So instead of risking 0.10% per trade, you would risk, 0.12% and so on and so forth.

Comes November, You are currently risking 0.20% per trade. Now, it is time to de-risk down gradually down to 0.10% so as to start January with a low risk, low concentration portfolio, ready for the new year. Remember: in the investors mind, January is the beginning of a new year, not the continuation of last year’s market.

C. Risk:“how much is enough?”, Steven Seagal, obese mythomaniac

You will often read that you should not risk more than 1–2% of your capital per trade. This does not mean position size, but equity at equity at risk. In your case, if you apply that rule over 5 stocks, one bad month and game over for good. So, get a better bad idea …

What is the maximum risk You can afford on each trade? This is one of the thorniest questions in financeI have pondered that question for years, until one day i came up with a simple elegant solution. Input variables

1. Drawdown tolerance: If Your investor redeems, game over. he said he would tolerate -5% max drawdown. So, in order to be safe, you should probably calibrate your risk to a fraction of this. If You calibrate at 100%, he will redeem and this is one time where being right is bad, very bad. Besides, you need to rebound from drawdown, so let’s say somewhere between 50%-66.67%, say 2/3
2. Avg number of positions: over 1 turnover cycle, what is your average number of positions? let’s say: 50
3. Loss rate: over 1 turnover cycle, what is your average loss rate. In case You don’t know use 60% as loss rate (Yes, it means you lose more often than win, and it is called prudence)

Equipped with this:

Max risk per trade = Drawdown tolerance / (Loss rate * Avg #positions)

= 5% * 2/3 / [50* 60%]

Max risk per trade = 0.11%

Now, that was the max risk per trade. Let’s move to the min risk per trade. This is a fraction of that: usually 40%. So, your min risk per trade would be around 0.05%

Add trading has a cost: 0.036% blended avg, between DMA and high touch at Credit Suisse for example (as a good friend complained again this morning while we were naked in the gym shower !?!).

Now, You probably start to understand why i mean that those customers are toxic. When You go through a drawdown and you will have rough periods, You will simply not be able to dig yourself out.

Conclusion

Once in early 2013, i was cruising at a hedge fund party nursing some nasty Chardonnay and some dude who just launched was explaining his strategy:

-“fundamentals pairs trading”, he proudly said

-“So, You must be Long Toyota and Short Mazda, right? Mazda has gone up 400% and Toyota 30%. That must be a painful trade? ”, i asked

-”Nah, positions are small anyways, so no it does not hurt”, he confidently replied

-”Well, if they are too small to hurt, do You think they are big enough to contribute?”, i candidly asked

And he did the unthinkable rudest thing someone can do in Japan. He gave me back my business card and walked away

How should I manage a client’s portfolio if he wants a 8-10% return and no negative years worse than -5%, and has a starting amount of $2…