"The wise are instructed by reason; ordinary minds by experience; the stupid, by necessity; and brutes by instinct.” – Cicero, Roman author and politician
The Problem: Investments with little downside, but also limited upside (Value Traps) can gain prominent position sizes because of their limited risk, but end up being poor use of capital. This inefficiency is caused by the basic human instinct of loss aversion.
Tversky and Kahneman, pioneers in cognitive psychology, found that the disutility of a loss is about 2x greater than the utility of an equal gain. What this means is that the pain of a loss of $100 is about the same as the pleasure of winning $200. This effect explains how emotion takes over when losses occur. Compounding may explain this emotional response because the impact of a portfolio loss is more detrimental than a commensurate gain is beneficial. So, our instinct is partially right to love an asset with downside protection, but the cost of downside protection must be measured.
As an example, take a stock that is trading at $9 with $8.50 per share in cash. It is easy to get fixated on the limited downside, but there are two sides to every analysis — (1) what happens if things go according to plan and (2) what happens if they do not. If things go well, the company will earn $0.10 per share and could trade for 15x earnings or $10 ($1.50 of earnings per share value plus $8.50 per share in cash).
If the stock hits its downside, it is worth $8.50. Even if you believe the probability for success is high, say 90 percent, the risk-adjusted return is only 9 percent, and this Value Trap is a mediocre use of capital. If we assume the Value Trap is a 5 percent position, substituting its exposure for an asset with a 25 percent risk-adjusted return would increase portfolio return by 80 basis points or $8 million for a $1 billion fund.
The Solution: Use risk-adjusted return to determine asset quality. The explicit estimate of profit and loss required to calculate risk-adjusted return will highlight Value Traps and make them easy to avoid. Position sizing will become straightforward as the risk-reward can be tied to exposure to maximize the risk-adjusted return for the fund.
Additionally, the research conversation will be focused on the elements of the analysis that are critical for making portfolio decisions: how much can I make if I am right, how much would I lose if I am wrong, and what are the probabilities of each?
Click here for the solutions to:
Mistake #1: Discounting the Downside
Mistake #2: The Good Stock Paradox
Mistake #5: Higher Return Does Not Always Mean Higher Risk
Mistake #6: What Is Your Sixth Best Idea?
Mistake #8: The ETF Hedge (The non-Alpha Short)
