Money Management


A lot of books have been written about managing money focusing on a single instrument or gambling games. But I personally did not find any comprehensive material which dwells deeply into money management for equity investing. I do not have any professional background from the fund management industry nor am I very proficient in mathematics and programming (though I would rate my self above a beginner in both). In this page I have tried to note down how I approach money management for my equity portfolio. In no way it is the only or the most comprehensive approach. 

Disclosure: I am not a registered adviser or an analyst so this is to be taken as an educational content. You may chose to apply these ideas but the risk & reward associated with it will be yours.

A brief background

The most inspirational & sometimes almost like a Hollywood movie is the story of Ed Thorp beating the casinos. Thorp (one of my investing & life heroes) is a man who wants to try everything on his own & approaches life with the highest dose of rationality. Thorp met Claude Shannon (another genius) while working at MIT where they build the first wearable computer to beat Russian roulette. There Thorp developed a card counting method as he had a mathematical edge in the game of blackjack. Where money management kicked is in the problem statement - Given an x% of edge in a game what fraction of your bankroll should you bet (how much money from your cash pile should you put in the trade/game). Thorp relied & modified a betting strategy based on John Kelly's paper of 1950s at Bell Labs. Michael Mauboussin recently in the 2000s wrote a good paper on this too. There is a book on the same subject but I suggest to read it only if you are mathematically inclined. For a more entertaining content read the book Fortune's Formula.

But as of now don't read anything above. Why? Because the Kelly criteria application to long term equity investing is a tad complicated. We can achieve a good intuitive way to maximize our bankroll based on this principle which at the core is to bet optimally to have maximum potential gain with minimum chance to go bust.

Core Principles

There are a few rules (5 Ps) I have set for myself. They include the following:
  • Practice reversion to mean in the valuations of the overall market, it is natural & definite
  • Play alongwith the trend until it bends
  • Protection of capital is more important than appreciation of capital
  • Prediction is futile
  • Perfect is the enemy of good
With this lets delve into the 4 dynamic facets which we need to focus on. 

The levers of money management

There are 4 critical levers which we need to monitor. Before going to discuss those it is assumed that your or my system of investing (be it fundamental or technical) generates trades which we enter into. Once entered into then this money management framework kicks in. The 4 levers are:
  1. Equity - Debt Allocation (ED)
  2. Portfolio Value Trend (PV)
  3. Thesis Change (TC)
  4. Individual Stock Drawdown (ID)
Usually as humans we like to apply linear logic. In this case we would assume a top down or a bottom up application. But that is not the case in my system. Any of the 4 levers can get activated for a decision to be taken and trade to be entered.

What usually happens is at least 1 lever gets pushed and then we have to look at all four to take an action. If none of the levers get pressed we run on auto pilot. I will clear what I mean by pressing the lever means later. But a brief intro each of the levers is below.

Equity - Debt Allocation (ED)

This is a method to define how much part of the bankroll do I have invested in equities versus how much I keep as cash. When someone says that he is 100% equity it means all his portfolio is invested in stocks. When I say I have 30% in equities it means say 30 lakhs from my 1 crore portfolio is in equities and the remaining 70 lakhs is sitting as cash. By 'cash' what I mean is any of the debt instruments which have a 'lower' risk. I prefer liquid funds, money market funds and fixed deposits. I try to spread them across AMCs and banks and even family accounts whose money I manage. The objective is not returns in this portion of the portfolio but safety. While writing this we are getting approximately 6% post tax returns on this part of the portfolio.

So how do I define what percentage of equity should be invested. Here the first principle applies 'reversion to mean in valuations is natural & definite' for the whole market. I have data of Nifty 50 PE reported since Jan 1999. Please note this data is as reported by NSE and has certain drawbacks such as composition of Nifty 50 changes over time with additions and exclusions. Also these are standalone numbers. But for my analysis which is more trend based these do not make a large difference. Also apart from PE of Nifty 50 I keep a tab on Nifty 50's PB but this is secondary & mostly for the 'lending' business part of the portfolio. In my active investing career which is mostly after 2008 I have not had any issues with PB. But PE is a different animal altogether.

So here is the Nifty PE chart since 1st of January 1999. I plot this as a distribution and then look at percentiles of Nifty PE. 



So when we plot this on a normal curve we start getting a good picture of how over heated the market is or vice versa. For instance on 23rd March 2020 the probability curve was as below.


I break the distribution to a few zones mostly quartiles as below.

PE Percentile Time spent Max Equity Allocation
0 to 25 25% 90%
25 to 50 25% 80%
50 to 75 25% 70%
75 to 90 15% 50%
90 to 95 5% 35%
95+ 5% 25%

Meaning during June 2019 when Nifty PE was at the extreme right in the above bell curve I wanted to have a max equity exposure of 25% and today when it is approximately at 50th percentile I want to be not more than 70% in equity. I always want to hold 10% cash at the minimum so that in the extreme event of going below historical lows I still have some money to buy if required.

I also look at the PB charts in the same manner as above. For instance in January 2018 PE period (95%ile+) the PB was still at median levels so I was not very worried about leverage.


From this lever we get an output of - maximum percentage allocation to equities.

So we have a broad back of the envelope framework for managing equity debt allocation now lets move on.

Portfolio Value Trend

This is quite simple. I plot a portfolio value chart for all my equity and total portfolio. Something on the lines below. I look at the monthly returns of my portfolio whether it is trending up or down (rarely same month on month). The ways to calculate this is by maintaining a record of all cash flows across equity and debt and getting portfolio values at the end of every month. Cashflows can be easily calculated from bank account statements and monthly portfolio value can be calculated from the NSDL CAS satetment.



So from this lever we get an output as whether overall portfolio is - going up or down

Thesis Change

This is the most arbitrary of the levers and at the end of the article I will give real examples of how I have done with specific instances. What Thesis Change essentially means is that the reason for investing in a business no longer holds valid. There is a tremendous amount of ways in which people arrive at reasons to buy - within fundamental school you have value, growth etc., technical via charts, momentum, statistical, factor investing and so on. Everyone's thesis might not have a target price. I do not have that too. I do not want to deep dive into this lever because it is vast, as vast as the expanding universe. But in brief I will outline what I like.

In the non financials which forms most of my equities I like companies with excellent returns on capital, good growth, free cash flows which have to exceed cost of capital and low to nil debt. In the financials side I check whether the company can have its capital returned. I look at return of equity primarily but am very cautious owing to some mistakes I have committed in the past. There are no hard and fast rules here but more discretionary.

I look at price trends of a stock if I have shortlisted. I calculate something called Trend Factor. Basically it is what percentage of time does that stock remain in a clear up trend (defined by a basic moving average system). I like to have my stocks trending upwards. Who doesn't I would say!

So from this lever we get an output whether the thesis of investing in a company has - changed or not 

Individual Stock Drawdown

What is max drawdown? Maximum drawdown is defined as the maximum fall in an investment from the peak in the past to the lowest point after that peak. Suppose my portfolio had a value of 100 in January 2020 but in April 2020 it fell to 70 and then in June 2020 it rose to 85. My maximum drawdown will be 100 - 70 = 30. This can easily be calculated in a spreadsheet.

There are two ways to look at Max DD (short for maximum drawdown). The first is the individual stock position has drawndown and the second is that because of the stock the portfolio has drawndown. So for example we hold a stock with a weightage of 15% in our portfolio. It falls say 25% and assume this is the limit of the drawdown I expect for this stock specifically then this lever goes off for this stock. Now this same stock assume drew down by 20% and its impact on my portfolio was only 2% then I will not have this lever pressed as it neither passed my 25% individual drawdown criteria nor did it pass (for assumption sake) a total portfolio impact of 3%. 

How do I calculate the individual drawdowns of each stock? It's possible. I again look at all historical major drawdowns of 20% or more of each stock. It takes some time. But with that data I have a table for each of my stocks as to what Max DD it has had in the past. For instance say an HDFC bank Max DD for last 21 years has been 55% once that is, 40%-50% Max DD 3 times, 30%-40% Max DD 7 times, 20%-30% Max DD 12 times. This gives me a rough estimate how deep can I go individually into red (in terms of DD) for each position. Note I have just made up this data but trend is similar.

From an overall portfolio impact I simply calculate whether say a 50% Max DD in HDFC Bank (assume this is the threshold I have kept) on a 15% weightage in my portfolio has 5% impact then I will press this lever. At an overall portfolio level I have hard coded this level at 5%. I am yet to think more statistically on it. Luckily in last few years this has not had a heavy dent. 

So from this lever we get an output as whether Individual Drawdown is - hit or not

A short note on Capital Allocation

Though Capital Allocation is something which is very crucial is often overlooked. I hold from 12 to 15 stocks in my core equity portfolio. In my satellite portfolio which is much smaller I have a very long list of stocks. Stocks qualify from this satellite to move into this core group. And a stock from the core group can go back to satellite or totally out. In the satellite I do not bother about any allocation but in the core group I do. I try not to exceed 20% holding in one single stock and not below 2% in any. As I write my top holding is 15% and smallest holding is 3%. How I allocate is basis the confidence I have in my thesis. Also I tend to build a position over a long time frame in months and even over a year. If any of the levers or a combination get hit I tend to withdraw but override my rules sometimes (a mistake).

Bringing all Levers together

Now any of the levers can get hit individually or collectively. The outputs to monitor are below. Except equity debt allocation which is a number the rest are all binary (rarely 3 outcomes in one lever).

Equity Debt Allocation: Increase, reduce or hold
Portfolio Value Trend: Up or down (rarely same)
Thesis Change: Holds or doesn't hold
Individual Drawdown: Hit or not hit


Once any lever gets pressed we need to take decisions. The decision making framework is also quite simple. Suppose one lever gets hit then we have to take an action. We also see what is the impact on other levers. Now I will share examples by changing each of the 4 levers. There are actually 24 such cases possible. So I will share some of the key live examples which I have gone through.

Once a lever gets hit an action has to be taken. That action is usually a trade. The trade can be in the form of:
  • Exit: Sell full or partially
  • Do not exit: Average down or average up

List of Examples
  1. Market overvaluation 2017 - Lever hit Equity Debt allocation. Result: High Debt allocation
  2. Market fall in Dec 2015 to Feb 2016 - Lever hit Equity Debt allocation. Result: High Equity allocation
  3. Market fall & stock position in YES Bank in January 2018 - Levers hit Equity debt allocation and Individual Stock Drawdown. Result: High Debt allocation & stock exit
  4. VA Tech Wabag - Lever hit in Individual Drawdown. Result: stock exit
  5. Tata Elxsi - Lever hit in Individual Drawdown. Result: stock exit
  6. RBL - Lever hit in Individual Drawdown. Result: stock exit
  7. Avanti Feeds -  Levers hit Thesis Change and Individual Drawdown. Result: stock exit
  8. HDFC Bank - Lever hit in Thesis Change. Result: Position not changed
  9. HDFC AMC - Lever hit in Thesis Change and Individual Drawdown. Result: Position not changed
  10. Borosil - Lever hit in Thesis Change and Individual Drawdown. Result: stock exit

1. Market overvaluation 2017 
This period was one of the most over heated periods in terms of valuation of the index. Index was touching 97%ile and 98%ile continuously. Then in late 2017 and early 2018 we started seeing a correction. The ED lever indicated to go 30% approximately in equity and at that time I was perhaps 60%+ as far as I recall. In second half of 2017 I started booking profits in stocks to bring down my equity exposure which I still did not get to optimal levels though.

Trigger hit: Lower ED
Action: Exit by selling some positions fully and some partially

The stocks which I felt had no thesis change I tried not to sell or only partially for instance I did not sell a Pidilite but sold YES Bank later in the year and beginning of 2018 exited completely. 

2. Market correction in end of Dec 2015 & beginning 2016
I could not understand the correction in that period but once market corrected I wanted to increase my equity allocation. I did not have a strong thesis to increase some of the positions I had. I had one good idea then in my satellite portfolio (Maruti) which I had brought to core in early Jan and Feb 2016. 

Trigger: Fall in PE. Increase ED
Action: Increase portfolio size (satellite to core movement)

3. YES Bank exit & market correction in early 2018
The market was extremely over heated in early 2018. My thesis around YES Bank which at that time was my largest holding too was not very firm. With the recent spat going around with the regulator I was not very confident of YES. So as the portfolio drew down this large position hit its overall impact on portfolio. Having little confidence I exited the entire position in one shot. 

Trigger: Drawdown in stock & portfolio and overall market heated
Action: Exit top position completely

4. VA Tech Wabag Exit
This was a complete miss on my part. I held this with a wrong analysis. So when price started correcting it hit the individual max drawdown. I exited at a loss. The position did not impact the overall portoflio.

Trigger: Individual drawdown in stock
Action: Exit position completely

5. TATA Elxsi Exit
Thesis for me changed in this stock and this was preceded by a stock collapse. A very large winning position converted into very little gain. I decided to bite the bullet and exit the position.

Trigger: Thesis change and individual stock drawdown
Action: Exit position completely

6. RBL Bank Exit
Just before the budget in 2019 this stock began an accelerated price drop as far as I recall. It hit my individual drawdown levels. I partially exited as I was firm with the thesis. Then after discussion with an experienced investor I was convinced to sell completely. Also I did study all the loans made by the bank to more than 10 bad companies or rather the worst companies from the MCA website. This convinced me the thesis had indeed changed.

Trigger: Individual stock drawdown
Action: Partial Exit

Trigger 2: Thesis change
Action: Full Exit

7. Avanti Feeds Exit
This was a find in 2013-14 for me. My thesis was not very firm initially so I build on the position as time progressed. I did some profit booking in 2017 but that was more discretionary I think (a mistake perhaps). Then in 2018 Feb as I recall the stock fell drastically. I exited.

Trigger: Individual stock drawdown and thesis change
Action: Full Exit

8. HDFC Bank Maintain Position
In March 2020 COVID-19 led to one of the fastest drawdown every seen in the history of markets. Analyst reports cut the target of HDFC Bank owing to foreseen impact. But my thesis from a very long term point of view did not change but the price drew down.

Trigger: Portfolio Drawdown
Action: Average down to maintain position so that portfolio drawdown gets nullified to an extent

9. HDFC AMC Maintain Position
Post listing for a few days the stock shot up but then it started falling aggressively. The stock was written off and it was claimed that insiders were selling. For me the thesis of the business did not change at all.

Trigger: Individual stock drawdown and no thesis change
Action: Average down to maintain position so that individual drawdown gets nullified to an extent

10. Borosil Exit
I like the products and was influenced by that. The business metrics were not very strong in terms of working capital and return ratios. Though the company had been gaining market share. But the price drew down. This was the second time I invested in this company. The first time was a good trade. My thesis did not hold as the numbers did not reflect the same.

Trigger: Individual stock drawdown (satellite portfolio) and thesis change
Action: Complete exit in the stock

Few thoughts

As you would have understood this is just a framework and not an automated system. Many of the levers are quantitative especially Equity - Debt allocation, Individual Stock Drawdown and Portfolio Drawdown. Thesis change is very subjective. I encourage you to play with numbers and see what happens. 

A hypothetical situation is when the ED allocation is right and no stock has hit drawdown levels but portfolio is trending low. That means I have the worst of the stocks and thesis is perhaps not right. Like I said earlier there are a total of 24 scenarios and all require an action be it exit fully or partially and maintain position by increasing via averaging up or down or doing nothing. Many a time it could be that I will exit much before or underperform because of low equity exposure.

What would be the results you might wonder? The result is what Mr Buffett states in his earlier partnership letters of the 50s and 60s. He said multiple times then that in a roaring bull market the portfolio might seem to underperform the market and peers. But in a bear or a falling market the portfolio will seem resilient and non-penetrable. It is survival in bad times which increase longevity in the market. 

We go back to our 5 core principles. I hope that this framework does justice to all of them. 
  • Practice reversion to mean in the valuations of the overall market, it is natural & definite
  • Play alongwith the trend until it bends
  • Protection of capital is more important than appreciation of capital
  • Prediction is futile
  • Perfect is the enemy of good
All the best to your trading & investing

Ciao!

Comments

  1. Very good read. Would appreciate if you could have thrown more light on When you shift a stock from Core to Satellite and Vice-Versa and what are your thoughts on idea generation?

    ReplyDelete
  2. Thank you. Satellite to core and vice versa is like moving a business I am tracking to my core portfolio if thesis gets verified. Or thesis breaks down or price collapses and thesis is still doubtful for a movement from core to satellite. Lets take some examples. Not a stock advice.

    Satellite to out:
    I liked Caplin Labs in 2018ish but the DSO kept inching upwards. Then Mr Paarthipan came on some business channel and calmed the people down that its the nature of operating in Latam. I had the stock in my long list (satellite) but had removed it from there too. I still like the stock and have been reading up again but this problem persist. I can't conclude.

    Satellite to Core:
    I wont name the stock but it is again a pharma company I was tracking for a few years. I could see it being a leader in some of the fields they were in. It was fairly priced in 2018ish- 2019 early. So I increased the position as I was expecting good top line. It has an unlisted entity and there were some questions in my mind. It is part of my core at the moment.

    Core to Satellite:
    I held RIL for many years in my personal portfolio. In mid 2019 I moved it out to satellite because I wanted to be not invested in either telecom or oil. I wanted to hold a concentrated portfolio and it would not make the cut.

    I hope this is helpful.

    Idea Generation:
    I am very active on the Valuepickr forum. I might not post much but I read up a lot. And almost every day I have some screens I keep running on screener. Tweaking them to come up with ideas. Also more importantly I try to keep my eyes and ears open and listen to what others have to say.

    Regards
    Deepak

    ReplyDelete
  3. How do you position size for your individual stock picks as you move them from satellite to core? Is there a set formula or as you mentioned it is based on the confidence of your thesis?

    ReplyDelete
  4. No I don't position size basis formulas. But I never build a position immediately. I follow some price action and take time to build a position.

    ReplyDelete
  5. Great read Deepak. One query:I terms of pe/ pb based allocation, due you use assign weights between pe and pb levels to get to final equity allocation? Our is it solely based on pe. How do you use the pb data? The Jan 2018 example was not very clear from a pb perspective

    ReplyDelete
  6. I had tried to use PB with varying weights for instance 50:50 and the resultant peaks still happen in dot com and gfc owing to leverage. The period which is now is at 99th percentile on PE but even below median on PB. The thing is that corporate earnings are very poor and price is not correcting. Doesn't seem like a good combination honestly.

    ReplyDelete
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