diversificationEconomics

I lost £10,000. Here is what I did wrong.

The backstory

In 2017 I bought about £10,000 pounds worth of shares in the trust that was managed by Neil Woodford.

The vehicle was called the Woodford Patient Capital Trust (now probably famous in the UK). Its aim was to deliver high single to mid double digit returns to investors over the long-term. In other words, the returns were to be expected after about five years of letting the capital to work.

While £10,000 may not seem that much, and indeed, in the context of financial markets it isn’t, it represented about 50% of my savings at that time.

Tip: look at the money you risk investing not as quantity but as percentage of the liquid capital (cash) you have saved and, importantly, you don’t need. This will help you measure the risk you are willing to take.

The trust had around 100 holdings, but it was typically concentrated in the top ten. Therefore, while the capital of the trust (around £800 million) was spread across 100 companies, the bulk of it was put at work in 10 holdings – known as “high conviction” bets.

See for example below.

I thought that the exposure to a number of industries throughout the trust, as well as to different market capitalisations and geographies was enough to diversify the capital concentration in the top ten holdings.

Spoiler: it was not.

The basics of diversification

The video above is a collection of words from well-known and successful investors telling people that diversification is lame. But, unless you have F.U. money, I’d say that as a general rule of investing your savings, you don’t want to follow this advice.

There are many great books, papers and, more recently, tweets about how to diversify your investments. I will however highlight one of the best articles that I’ve read on this topic, and it comes from Ray Dalio, CIO of Bridgewater Associates.

You can read the more in depth analysis in the above article or in this paper, but to cut the story short, there are various levels of diversification:

  • Between asset classes (spreading your investments across bonds, stocks, commodities and so on)
  • Within the same asset class (for equities for example, this means spreading the money across value and growth stocks, as well as buying across the capital structure via different share classes)
  • Across geographies (buying investments in different countries, with different political climates, economic needs and levels social cohesion)
  • Through adding a manager overlay (giving your money to different active asset managers, with different strategies, to allocate them)

The idea here is to reduce asset price correlation. In other words, diversification should allow you to at least break even (i.e. protect your capital) by getting exposure to assets that see their prices move in different directions during times of turmoil.  

It doesn’t matter if you buy multiple investments that see their price fluctuate in the same direction in certain market environments: if that happens, you haven’t diversified well.

However, there is a caveat to this. When the world is awash in money, correlations turn more positive. In other words, when there is a lot of liquidity (purchasing power, cash, credit, money) in the markets, herd behaviour is not just enabled but amplified.

a-world-awash-in-money-fig-02-2_full

However, before worry about this, focus on getting the above levels of diversification right. That was my mistake: I didn’t get them right.

How I lost the money

Part of my savings was allocated in other assets (commodities and fixed income, through ETFs) but it wasn’t enough to make up for the bigger mistake: the failure to diversify the active asset manager. In other words, I was missing a robust manager overlay.

The total risk behind the Woodford Patient Capital Trust was made up of:

  • The risk associated with each equity holding, in proportionate to its weight in the trust
  • The risk associated with the trust’s market price relative to NAV, or net asset value
  • The risk associated with the nature of the trust’s holdings (how much was liquid vs illiquid)
  • The risk associated with the manager of the trust (key man risk, primarily)

By allocating 50% of my savings to this vehicle, I eventually realised that I put an outsized bet on the aggregate of these risks, but especially on the active manager risk.

When it comes to active managers, the market attaches a premium to their reputation. What this means is that in times of turmoil, depending on how the manager has done in the past – especially in the more recent years – investors will decided to sell or not.

Of course, a good reputation can carry the manager only for so long. If the portfolio companies do not deliver as expected for a sustained period of time, then the speed with which the reputation erodes can increase. In other words, the active manager risk can magnify all other risks.

This is exactly what happened.

Neil Woodford’s ability to deliver returns with the trust, despite good performance for the first couple of years, was impacted by some high profile disappointments, like Prothena (a healthcare company that saw its most anticipated drug fail). This resulted in a revaluation of these holdings’ value and thus of their contribution to the trust’s NAV. Meanwhile, the press was increasingly negative on the prospects for other products managed by the active manager, weighing on investors’ sentiment even further. This resulted in [persistent] selling of shares.

I bought more as the shares dipped further down. After all, this was a long-term investment and that’s what you do if you are a long-term investor who believes in the allocations made: you back them with more money when the price goes down.

“Value is what you get, price is what you pay” – Warren Buffett. Sure, I did that, but I ignored the below equation:

Perception of manager x Disappointments in the portfolio = Overreaction on the downside.

Eventually, the product’s price collapsed and when I sold, just a few days before the asset manager closed down, I took a net loss of about £10,000.

The lesson

Three words: “key man risk”.

Institutional investors know this concept as it is in all their due diligence questionnaires. It seeks to understand what would happen with their money in case the fund manager is unable to do their job for whatever reason.

These three words encapsulate the need to spread your “key man risk” – invest with multiple managers which have different styles and philosophies.

When you give someone else your money to be allocated, you back that person’s investment philosophy and approach (i.e. the implementation of that philosophy). It’s always good to be exposed to a broad range of ideas and different styles of executing ideas. Some will turn out poorly. But others will succeed.

Only by diversifying your active manager exposure, or improving your “manager overlay”, you’ll mitigate the “key man risk”.

Bonus tip: Invest in art.

Art is an overlooked asset mostly because it is thought to be difficult to value (what isn’t?) and because some investors are worried about liquidity. But these two hiccups shouldn’t prevent you from taking a good look at the world of art, especially now with the world awash in cash, paper assets (that is, financial claims on real assets) are increasingly worthless.

The alternatives are not that many: property, commodities, cryptoassets and art.

Art is not only for the ultra-rich. The quality art market is large enough to offer attractive prices for beginners. Start small and build up. If you are interested in the featured image painting, you can find out more here.

Categories: Economics

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2 replies »

  1. Losing 10,000 pounds must suck, especially if it’s 50% of your savings. I hope this taught you to not put all your eggs in one basket!

    Have you read Rich Dad Poor Dad? Great book for learning about finances and whatnot. Taught me that fancy cars and houses are not assets, but liabilities.

    • You bet – I did learn to look at risk from as many perspectives as possible and, importantly, to put aside loyalty to an investment thesis or process. Being flexible when investing is so critical.

      I read the book a while ago. Good book. I suggest looking into CrossBorder Capital’s work (they have some free stuff on their website which is very good and regular YouTube updates). I think you’ll find it interesting.

      Thanks for the comment,
      Anton

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