Speculation, Illiquidity, Path Dependency, and How They Make Sense Together

As I mentioned in “Revising My Emotional Risk Tolerance v2“, I became very fidgety due to lack of emergency cash. One other detail I forgot to reveal is my cash flow is irregular, which just boosts my stress levels even more when money I can’t afford to lose has potential to be permanently lost.

Considering all these facts, a purely Great Company strategy as proposed in “Revising My Emotional Risk Tolerance v2” is probably not the best solution actually as I risk running into two kinds of problems: High Opportunity Cost and Illiquidity.

High Opportunity Cost comes in the form of missing out returns due to Speculation. Re-reading Chapter 8 of Intelligent Investor made me shamefully admit that I was engaging in market timing rather than price timing, something that would make me miss out returns because I was not fully invested since I can’t have 100% accuracy in market timing.

Illiquidity comes in the form of not knowing when to sell Great Company stocks. Great Companies work well if held for long periods of time, but this strategy causes lots of problems for small investors if they intend to live off of Great Company stocks alone as it requires large sums of cash on hand to survive the time period for Great Company stocks to resume to intrinsic value, and also uncertainty behind the timing of not prematurely selling Great Company stocks would also give me a lot of un-necessary stress if my living costs depended on it.

Active Indexing also just doesn’t make sense because returns aren’t sexy for the amount of capital required to stay invested. Adding the fact that it makes it hard to transition into other higher return investment strategies due to uncertainty of timing (eg. I might need $100,000 HKD to have enough diversity among stocks to kick start an investment strategy, but the index ETFs may drop in value right before I’m about to kick start, delaying plans indefinitely).

This is why difficult Path Dependency of Active Indexing is the nail in the coffin for me, because ultimately I should take advantage of investment strategies that have low competition to increase high returns rather than getting stuck in low return investment strategies indefinitely, since Charlie Munger’s advice for small investors has always been to:

Don’t go after large areas. Don’t try to figure out if Merck‘s pipeline is better than Pfizer’s. It’s too hard. Go to where there are market inefficiencies. You need an edge. To succeed, you need to go where the competition is low. That’s the best advice I can give to small investors.

My qualms with jumping directly into a NCAV stock strategy though, was the requirement of a decent chunk of money to diversify among 20+ stocks and the time period needed for profits to materialize (2-3 years). The lack of capital to diversify among 20+ stocks without getting killed in commissions and the cash flow problem I presented in the beginning makes it a problem for me to deal with the illiquidity of NCAV stocks.

I have however realized a way to invest that would be great as a transition between a standstill situation to a fully invested NCAV stock strategy, which is Joel Greenblatt’s Magical Formula strategy.

The similarity in style of buying undervalued stocks and selling it and the similarity in the need for diversification makes it easier to transition as I can rotate into NCAV stocks the more capital I have at my disposal.

Another beauty of the Magical Formula strategy as a transition is the short holding period required (1 year), which means I require much less capital to start investing. This allows me to reduce my cash reserves from the target of 18 months to 12 months since in the event of being laid off, by the time I finish off my 12th month of expenses in cash, my Magical Formula stocks would be liquidated in time to extend the time I can have to find my next job.

My plan of action for now as a result would be to first ensure I have 12 months worth of expenses in cash, and then buy 1 Magic Formula stock / month with at most 2% commission [1]. I will stick to large cap companies during this period of only buying 1 Magic Formula stock / month, to counteract low diversification (Joel Greenblatt recommends at least 20 stocks).

As I have more and more capital, I will aim to buy 2 Magic Formula stock / month before trying to reduce commission to at most 0.50% [2]. Any extra stock I can afford beyond 2 Magic Formula stock / month I will then contemplate on either buying more Magic Formula stocks or NCAV stocks instead.

The reason why I will maintain buying 2 Magic Formula stock / month even after I start buying NCAV stocks is because the strategy only works if I persevere even when it underperforms the market, thus requiring full commitment through cycles of over-performance and under-performance in order to reap the benefits of the Magic Formula strategy instead of foregoing maximum profits prematurely.


[1] The reason why at most 2% commission is because the backtests of Magic Formula shows that it beats the market by 4+% under realistic conditions. I want to make sure I at least make 10+% returns after commissions as I want to still be able to generate better than market returns’ historical average of ~6-9% returns.

[2] 1% management fee is the most I will pay for active managed funds. Two transactions (buy & sell) will make commissions take 1% of my return


Not advice. No offer. Do not rely. May lose value. Risky. Conflicts hidden/obscured. (Borrowed from Terrence Yang‘s Disclaimer on Quora)


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