Working on that White Paper
Back when I wrote about how to build a portfolio, I said that there may be a more in-depth white paper in my future. And while the plan is for that to still be the case, it turns out that trying to write an entire white paper at once is a pretty heavy lift. So in the spirit of turning one difficult-to-achieve big task into a larger number of easier-to-achieve smaller ones, I thought I might take our five tenets of portfolio construction one by one in this space and see what resonates.
As a reminder, if you’re trying to build a portfolio of any individual items that need to cohere to achieve a goal, here’s the checklist:
Know what you’re trying to accomplish.
Don’t risk more than you can afford to lose.
Diversify, but not too much.
Only take risks you’re compensated for taking.
Everything is more correlated than you think.
So if we’re going to take these one by one, let’s first figure out what we’re trying to accomplish. But before I get to hurdle rates and return thresholds, a short story about the u12 girls’ soccer team…
The team got moved up to a higher division this season and is therefore playing some tougher competition. One recent match against a reasonably tough opponent took place on a day when the wind was gusting up to 30 miles per hour. The girls won the coin toss and opted to play the first half with the wind, so the objective in a tie game with the wind at our back was to try to take a commanding lead. To wit, the coach fielded an attacking heavy portfolio of players and the team ended the half with a 3-0 lead.
But now with a commanding lead and facing a stiff headwind, the objective changed. That’s because all the team needed to do to win the match was not concede three goals. So the coach switched out several attacking players and replaced them with defenders in the back. They won the match 3-1.
Yet at the end of the match, some parents were frustrated. They wanted to know why their player had been subbed out when the first half had been so successful and cited as evidence the fact that the team lost the second half 1-0. And that’s one way to look at it. But the fact of the matter is that winning the second half wasn’t the objective. Rather, the objective was not to lose the second half 3-0 or worse, and while a more attacking-oriented line-up might have won the second-half outright, it would also have been much more likely to concede three goals. The defensive line-up, on the other hand, was unlikely to score any goals, but almost assuredly would not concede three or more.
In other words, in building a portfolio, objectives matter. And never try to accomplish more than you are trying to accomplish because in doing so you expose yourself to asymmetric risk. To use the soccer analogy, the incremental gain of winning the match 6-0 is not worth risking the catastrophic loss of turning a 3-0 lead into a 3-3 tie or a 3-4 defeat.
With regards to the definition of investing (“expend money with the expectation of achieving a profit”), knowing your objective means defining how much money you will invest and what the cost of that capital is in order to determine your investment’s capacity and required rate of return. Typically, those two things – capacity and rate of return – are inversely correlated. In other words, you are unlikely to find a strategy that can reasonably invest $1 trillion and double your money in a year, so it would be a bad idea to raise that much capital and bank on those returns.
If you’re investing your own money, your required rate of return should be equal to the return you could get taking little-to-no risk at all (i.e., US treasury rates) plus extra return commensurate with the risks you are taking. These risks can take many forms, but are academically calculated using proxies for traits such as volatility, creditworthiness, size, governance, liquidity, and more, which all try to layer in required return in recognition of the fact that a small, volatile, and poorly-managed private company is generally less likely to pay you back than a large, stable, well-run public one.
If you’re investing other people’s money (as we do at Permanent Equity), then those other people have likely calculated their own required rate of return and agreed to pay you only if you exceed it, so it’s pretty easy in this case to figure out what your minimum required rate of return is. In our case, we take no management fees of any kind and don’t get paid carry until our investors have earned a hurdle rate on their invested capital. We then receive a catch-up until we have earned our share and then split everything after that at a pre-agreed-upon percentage.
So one way of looking at that is that we shouldn’t get out of bed for any return less than what would pay us for our work, and that is indeed one way we look at it. Our objective writ large is to earn a return over time that more than reasonably compensates our investors and us.
Of course, achieving that is more nuanced than investing 100% in things that are expected to achieve that hurdle rate-plus because rarely do individual investments perform like they are projected to (some do better, others worse). So typically we try to underwrite things that will perform well in excess of that number in the expectation that we will be quite wrong every once in a while. Further, we demand higher returns from newer investments that are likely to correlate with existing investments because again there are diminishing returns from turning a 3-0 lead into a 6-0 win versus a 3-4 defeat.
If, on the other hand, you’re anything from an individual trying to retire to an endowment trying to fund a cause, establishing your objective means defining how much money you need to have at some point in the future and then working backwards to determine how much you have now and then calculating the sliding scale between the return you have to earn compared to the amount of money you need to regularly add to the portfolio in order to have that amount of money at that future time. If you are good at saving (if an individual) or raising (if an endowment) money, then your returns can be lower. If you’re not, they have to be higher.
Either way, if you have an objective and know what it takes to get there, it limits the scope of what’s possible and therefore increases the probability you can achieve it. And also, perhaps more importantly, prevents you from ever trying to accomplish more than you need to.
Have a great weekend.
-Tim