Life is all about Trade-Offs

Most of our investing career is just built around 20 to 30 years. The initial part is spent figuring out oneself and the strategy that suits oneself. The last part is mostly reaping the benefits and moving to a safer and income driven strategy.

Depending on how much you can save, the 20 to 30 years can provide for very strong growth in your asset base. But the issue is that once every decade or so, you will face a situation which makes you question everything you know and believe in.

Regardless of what kind of investor you are, there are always trade-offs to be made. As a discretionary investor who studies companies, bottom-up, there is a limit on how many Industries you can study and learn enough to be able to bet significantly upon. A systematic investor on the other hand has to make choices when he is building his algorithm.

We make trade-offs all through our lives. When we finish our 10th Standard Exam, we need to take a decision that will have an impact all through our life – should we take up Science, Commerce or Arts being the monumental question we are faced.

For Science, the trade off continues as they finish 12th. Should I go for Medicine, Engineering or pure Sciences? Each decision has a certain pay-off –  if it works, you congratulate yourself all through your life for a well made choice. 

When it comes to investing, it’s not very different. Should you invest on your own or should you invest in a mutual fund. The choices don’t end there. If you wish to invest on your own, what philosophy should you choose – Value, Growth, Quality or Momentum or a mix of them. When it comes to Mutual Funds, every fund house has a dozen or so funds trying to provide for any segment you may wish to invest and there are 41 such folks.

For the last two years, being a large cap investor would have provided you much better returns than a Mid or Small cap investor. But pull back a bit more, say 7 years and it’s not so much clear for quite a few funds outside the large cap universe provided similar if not better returns.

Franklin in the debt fund space had made a name for itself by producing superior returns. But when the chickens came home to roost, some of the Alpha got wiped out. But that is the nature of return – higher return comes with certain caveats including risk of capital loss.

Asset Allocation is a trade off. When you choose a conservative model, you are letting go of the upside for more protection on the downside. Today, it feels awesome to have a draw-down in single digits, but that is the trade off you made by willing to not having a large equity exposure.

I track PMS returns every month since unlike mutual funds, there is no publicly available database I know of. Anyways, one recent addition to the list I track is a multi-cap pms but one which I was told was more small cap oriented. The return since its launch (2013), an awesome 26% as of end february. The negative, well, even before we hit Corona, the fund was down 50% from its peak. At its peak, the CAGR was an incredible 60%. While it’s normal for their clients to feel bad about the recent performance, for those who came in early, the return vs risk is still very much acceptable.

If you are getting into equities today, you have a trade-off to make. Should you choose the well known large cap firms or the beaten into nothingness small cap. Few days back, I ran a poll asking where people were investing. 2 days back, I saw a similar poll by a AMC head. In both polls, very few claimed to be investing in small cap with Large cap being the first choice. Once again, the Risk and Reward is different for both choices.

As a quant, we make choices when we build every model. The Asset Allocator model for instance is worried about taking risks, the Momentum Model on the other hand is 50% invested even today. Different goals, Different strategies.

In the United States, it’s said that there has been a flight to safety. Investors as usual are fearful, not just about markets but about future prospects as job losses climb to numbers never seen. It’s once again a choice between probable future gains in equity vs the pain of continuing losses especially if that comes in even as one is unemployed.

Choosing the trade-offs themselves is tricky. In good times what trade-off you may feel is acceptable may not seem like a good trade-off when the times turn around. Ask Softbank as it tries to recuse itself from buying 3 Billion Dollars of We Work shares it agreed upon when times were better than its today.

In hindsight, we often feel that there was no trade-off to be made and the choice was very easy to make, but the reality is that there is always one. How you play it and the results makes us look back and think differently on the choices we were offered. 

The world today appears dark and bleak. It’s like a tornado has hit the town and we are in the dark in the Shelter. When we go back, things may not be the same, but human nature rarely chances in a matter of days let alone years. Investing should be driven by such constructs. The portfolio may not be “Antifragile”, but our behavior can be.