The Story of Investing – Stock Picking vs Risk Management

The subject of behavioral finance has explored the cognitive biases involved in stock picking and why this introduces an element of overconfidence in portfolio construction. Very often, you hear managers speak about the businesses they like with words like, “I understand this business very well,” or “I know the management very well and trust their execution,” or “I believe the valuation is cheap.” While there is significant merit in these statements, especially when they come from individuals who spend a considerable amount of time analyzing balance sheets and building models, it is imperative to understand that the returns of a stock always have a dependence of ~50% on macro environments, which could act as tailwinds or headwinds to the business.

Twenty years ago, there was an asymmetry and edge derived from one’s understanding of the business and potentially an edge in having more data than an average individual (for institutional investors). However, this edge has diminished over time, and one must be humble enough to accept this. As India’s market cap grows and we evolve into the top 3 market caps in the world, this will have direct implications on the importance of risk management (in deriving excess alpha) in portfolios.

A story to narrate to explain the value of unknown unknowns in future returns is below (around what constitutes good luck and bad luck):

The origins of this story are difficult to trace. It evokes an era where farming was the primary livelihood, horses were vital to farming, and conscription for military service worked just like in the Mighty Ducks movies where if the team captain shows up in roller blades at your home, your job, or while you’re eating lunch: stop what you’re doing because the team is getting back together and you’re on it, effective immediately.

So, the story takes place sometime between ancient times (200-ish BC) and the late medieval period (1500s). Most often, it’s set in China, although in some tellings, the samurai show up. In China or Japan, somewhere within a 1700-year interval, there was a farmer. One day, the farmer’s one and only horse runs away. The farmer’s neighbors come by to say they can’t believe it, “What bad luck!” The farmer shrugs, “Good luck? Bad luck? It’s impossible to know.” A few days later, the horse returns with a herd of wild horses, and the neighbors swing by again, “What good luck!” The farmer shrugs, “Good luck? Bad luck? It’s impossible to know.” A few days later, the farmer’s son is trying to corral the wild stallions when one bucks and kicks the son, breaking his leg. The neighbors, right on time, “What bad luck!” The old farmer shrugs, “Good luck? Bad luck? It’s impossible to know.” A few days later, the Han army or the Kamakura Samurai or some other large military unit shows up at the farm and demands that the son (Dad’s too old) stop whatever he’s doing because there’s about to be some bloody war, and they need the son to take up arms or sword or bow and arrow: he’s heading to the front lines. But when they see the son’s broken leg, they ride or walk away, and instead of probably getting killed, the son stays on the farm. Good luck? Bad luck?

Stock picking has many such parallels to the above story. You pick a good business (perhaps you have it as great in your mind, as it ticks all your checkboxes). There are a host of events around the business that can give a significant impetus to your story, or there could be multiple headwinds that you did not anticipate that could act as a drag on your returns for multiple years. It’s not just what you think of the business that matters, but how you manage your drawdowns if things go wrong that will determine your portfolio IRR. In essence, this is the core of risk management – which helps you manage the concentration of the business in the overall portfolio. There are times when concentration can give you an edge, and there are times when concentration can turn out to be a liability. Having a one-size-fits-all approach towards this will never be prudent risk management.

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