Our Research
The world does not need yet another market commentator. Our tools are designed to help investors along their investment journey
- Signals: trend reversal signals (Bull/Bear) on equity indices, Forex and government bonds
- Trading systems: simple steps from concept, back tests to auto-trade
- Money management: bet sizing algorithms, money/risk management tools
- Psychology: research and practical tools on habit formation
- Topics: discussions on the industry, trends
A powerful two step process to deal with the endowment effect: The game of two thirds, or how to deal with free loaders in your portfolio
Would You allow tenants to stay rent-free ?
If You were the owner of an apartment building, would You allow tenants to stay rent-free forever ? You would probably do everything in your power to either collect or evict free loaders. In the investment realm however, one of the main reasons managers fail to accomplish their goals is that they allow free-loaders to stay rent-free in their portfolios. The difficulty then is how to identify and deal with free loaders.
They don’t really stand out enough on an individual basis. Yet, as an aggregate free-loaders put a drag on performance.
- Endowment effect: once in the portfolio positions are sticky.
- How to identify and effectively deal with free loaders
- The 3 main benefits of the game of two thirds
Once upon a time, i used to place thematic small positions across the portfolio like pawns on a chessboard. They were supposedly hedges for China, precious metals, oil, monetary intervention etc. They were all tiny positions that were supposed to kick in if any of these themes were to gain traction. Six months went by and I could not understand why performance was so pedestrian. Meanwhile, none of those stocks had worked. Then, it dawned upon me that even though they were tiny individual positions, they totaled 10% of the portfolio as an aggregate.
The endowment effect (Thaler 1980)
Endowment effect is the hypothesis that people value more what they own than what they could buy. It is hard for positions to dribble their way into our portfolios, but once in they become sticky. It is difficult to get rid of them, even though they do not contribute. Some managers would hold on to losers just because they do not know what to buy next.
Our lives, our desks, our houses are filled with clutter. Unless we actively create and enforce rules to get rid of it, clutter creeps up on us. Our inner saboteur will always find good reasons to hoard junk. To illustrate its potency, let’s look at a simple example: in your wardrobe, isolate the clothes You have not worn for over a year. Think about all the excuses to keep them, but then ask yourself: “If i did not have it, would i buy it now ?” If not, then bye bye, fashion moves on and so should You.
The game of two thirds: A simple two-step process to deal with free loaders
Free loaders neither detract nor contribute enough to be visible. They don’t stand out enough to be dealt with. Since it is not possible to deal with them on the y-axis (price), the solution is to introduce time x-axis. Rationale is simple, if stocks have been there for some time, but still fail to contribute, then their weight should be reduced.
- Calculate portfolio turnover, divide it by three: first 1/3. Add 1/3 turnover to the entry date of each position. For example, a stock entered on January 5th and a turnover of 1 would yield a cut-off date of April 5th
- Divide performance in 4 quartiles, concentrate on the third quartile: second 1/3. For all stocks in the third quartile past their anniversary date, cut weight in half
Special mention for long-term winners
Apple (AAPL) or Softbank (9984:JT) are long-term winners. They sometimes go through extended periods of under-performance. Because there is so much embedded profit, it is difficult to realise that they have not contributed for some time. The idea then is to reset contribution on a rolling basis.
The idea then is to apply the same rules as above on a rolling basis. Instead of cutting positions to half, taking a portion the size of the out-performance from the previous haircut. For example, if Apple went up by 10% from previous haircut, then shave 10% off the current size.
The rationale is
- if it starts to underperform, it will be dealt with, and this profit taking will have cushioned the blow. This demonstrates stewardship
- If it continues to go nowehere, resources are re-allocated to a potentially more productive asset. If non-performance persists over 2/3 of portfolio turnover, then a more drastic reduction is in order
- if outperformance resumes, then it will be dealt with
It is important to periodically reset contribution. When stocks have been in the portfolio for a long time and substantially contributed, we become attached. Failure to reset contribution is one of the reasons why some managers escort their positions on the way up and then all the way back down. It doesn’t show until it is too late.
The three benefits of the game of two thirds
The game of two thirds may appear simplistic. It has however powerful psychological implications. It is a simple, powerful and objective way to short-circuit the endowment effect for three reasons:
- Simplicity: math is beyond dispute. Simple rules are elegant, easier to implement and harder to challenge
- Stewardship: great investors are not smarter, they have smarter trading habits. Getting rid free loaders builds the habit of dealing with difficult stocks
- The quality of our excuses determines the quality of our performance: one of the most frequent excuses is “what do i buy next ?” Constant re-examination of positions forces managers into action.
Discussion
Once in a portfolio, positions are often sticky. Asking ourselves “would you buy it again today ?” is too subjective to deal with positions that have overstayed their welcome. Our inner saboteur will find good reasons to procrastinate until the next review. Our natural instinct to hoard junk “endowment effect”. The game of two thirds is an elegant way to identify and deal with free loaders.
Daily #ETF signals
Thought of the day: “Sometimes by kising a battle, You find a new way to win the war”, Donald Trump, Happy Birthday
- VXX Bearish strength
- SCZ Bullish Weakness
- JKD Bullish Weakness
- IYF Bullish Weakness
- EWJ Bullish Weakness
- DFJ Bullish Weakness
- Complexity is a form of laziness
- Great traders are not smarter, they have smarter trading habits
- If investment is a process, then automation is a logical conclusion
- If You are interested in short-selling, trading systems, position sizing, trading psychology, visit us at: www.alphasecurecapital.com
- Bullish weakness: Longer-term trend is bullish. There has been some temporary weakness, but the uptrend is likely to resume
- Bearish strength: Longer-term trend is bearish. There has been some temporary rally, but the downtrend is likely to resume
- Volatility Channels (Horizontal dotted lines) : Markets often retest swings. This is a volatility buffer to allow wiggle room.
- Volatility Channel: Think of the other side of a volatility channel of the distance it would take to close half the position to break even if the remainder was to hit the stop loss
- #n%: Think of it as a rudimentary equity at risk position sizing. It is 1% divided by the distance from the day the swing is recorded to the volatility channel
- Disclaimer: this is neither a solicitation, nor an investment advice
Weekly #ETF signals
Thought of the day: “Sometimes by kising a battle, You find a new way to win the war”, Donald Trump, Happy Birthday
- PFF Weekly Bearish Strength
- EPU Weekly Bearish Strength
- Complexity is a form of laziness
- Great traders are not smarter, they have smarter trading habits
- If investment is a process, then automation is a logical conclusion
- If You are interested in short-selling, trading systems, position sizing, trading psychology, visit us at: www.alphasecurecapital.com
- Bullish weakness: Longer-term trend is bullish. There has been some temporary weakness, but the uptrend is likely to resume
- Bearish strength: Longer-term trend is bearish. There has been some temporary rally, but the downtrend is likely to resume
- Volatility Channels (Horizontal dotted lines) : Markets often retest swings. This is a volatility buffer to allow wiggle room.
- Volatility Channel: Think of the other side of a volatility channel of the distance it would take to close half the position to break even if the remainder was to hit the stop loss
- #n%: Think of it as a rudimentary equity at risk position sizing. It is 1% divided by the distance from the day the swing is recorded to the volatility channel
- Disclaimer: this is neither a solicitation, nor an investment advice
