The Relationship Between Macro Conditions, Affordability to Lose and Investment Style

By No machine-readable author provided. Mohylek assumed (based on copyright claims). [GFDL (http://www.gnu.org/copyleft/fdl.html), CC-BY-SA-3.0 (http://creativecommons.org/licenses/by-sa/3.0/) or CC BY-SA 2.5-2.0-1.0 (http://creativecommons.org/licenses/by-sa/2.5-2.0-1.0)], via Wikimedia Commons

I keep catching myself with the thought that I would invest differently if I were to be financially free.

If I weren’t financially independent, I couldn’t afford to lose the capital in pursuit of growth as it’s much harder to gain back percentage wise any losses (eg. 50% loss requires 100% gains to recover). If I wanted to become financially free by my early 30s, every step had to be careful to not lose capital.

This is the reason why I’m so attracted to Wide Moats. If analyzed and diversified properly, a portfolio of Wide Moats are structurally designed to survive recessions and continuously increase intrinsic value over all stages of an economic cycle.

The downside to this strategy of course is that your returns are capped. You can still beat the market, but not by much, since Wide Moats are usually well known large / mega cap stocks covered by tonnes of professional equity analysts, the opportunity of a Wide Moat misprice is usually few and not significant in magnitude.

So if a recession hits (Macro Conditions), in exchange for capped returns with a Wide Moat strategy (Investment Style), you won’t get wiped out (Affordability to Lose).

But what if I was financially free? How would I invest differently?

I would invest any excess money beyond the Wide Moat stock portfolio required to stay financially free into any type of asset that is well known for misprices (net net stocks, spin offs, merger arbitrage, distressed debts etc.).

The biggest risk to investing in assets well known for misprices is being wiped out when macro conditions sour. That’s the reason why I’m uncomfortable to invest in these assets while I’m trying to become financially free.

Assets well known for misprices are usually structurally not designed to outperform the markets if held for too long. The usual reason why the huge misprice existed in the first place was because structurally there must be something wrong with these assets, and that negative sentiment of these assets went way overboard.

The only way to make money from these assets thus is through a hit-and-run (buy when significantly cheaper than intrinsic value, flee at first sight of market price and intrinsic value merging).

So when a recession hits, these assets most likely die (eg. bankruptcy). If your portfolio was completely filled with these, you’d be screwed.

One way to remedy this problem is to hold lots of cash when opportunities are scarce. But a diligent investor will always find a mispriced opportunity if your investing scope is unlimited geographically and asset classes.

And even if you applied cash hedging strategies that took into account macro conditions (eg. hedge % of portfolio in cash based on Shiller P/E, Stock Market Cap / GDP, Samuelson Share), you’d run into the trouble of position sizing since how much you invest in each position.

Obviously, when hedging based on macro conditions, the amount of money you can invest varies literally day to day, so it gives you tremendous headache with position sizing as you have to figure out how much money you can invest divided by how diversified you want your portfolio to frequently.

So the only way I can find investing in assets well known for misprices working (Investing Style) is if you’re absolutely fine with losing the money dedicated to this strategy (Affordability to Lose) so that you can be fully invested regardless of economic cycles (Macro Conditions).

So until I’m financially free, I’ll stick to Wide Moats.

[Disclaimer]

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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