Monday, 31 August 2015

Are financial discussion sites dangerous for our wealth?

There are many investment websites where private investors and market professionals discuss potential investment ideas. Seeking Alpha, The Motley Fool, Stockopedia and ADVFN are just a few of the ones I regularly read. They can often be a fantastic source of knowledge, wisdom and experience as contributors from all walks of life freely discuss their investment ideas and strategies. When you add in Blogs & Twitter there are a myriad of ways to read or share investment ideas. While there are undoubtedly some misleading contributions from people who manipulate information for their own ends, in my experience most people who post do so out of a genuine desire to gain and share knowledge. And experience teaches you to spot those whose opinion could be questionable.

So why do I think discussion boards have the power to lead us to poor investment decisions? Primarily because contributors to these sites make very public statements about their opinions and psychology teaches us that once we’ve done that we find it very hard to change our minds on a subject even when the facts change.

The desire to appear consistent is a very powerful psychological effect. Robert Cialdini explains this in his excellent book, Influence: The hidden power of persuasion. He describes how getting people to agree to and write down statements was used to great affect by the Chinese Army on American POW’s in the Korean War. The Chinese would start by asking a POW to agree to a simple statement such as ‘America is not perfect.’ Since this was undoubtedly a true statement as far as the majority of POW’s were concerned then complying with this request wouldn’t have seemed a big deal. However once they had written the statement the POW’s would be asked to write a list of ways in which America is not perfect. Once they had agreed in writing that ‘America is not perfect’ it became very hard not to comply with the second request and add some details. This list would then maybe read out on the camp radio with their name making the public commitment complete. Compared to the harsh conditions of the Korean POW camps the Chinese camps were far more effective at getting prisoner compliance. Breakouts were very rare and given their public statements of compliance POW’s often turned in fellow countrymen for minor rewards such as a small bag of rice.

Psychology researchers replicated this effect in a kinder setting in an experiment conducted in California. They approached households and asked if they would mind displaying a small sign on their lawn asking passing drivers to ‘drive carefully’. Since careful driving in their neighbourhood was a public good that all householders were interested in and the signs were not particularly disruptive it’s not surprising most of those approached agreed to display the small sign. The power of the desire to be consistent with one’s former actions was shown two weeks later when the researchers returned to ask if the householders would mind displaying a much larger and uglier ‘Drive Carefully’ sign that they’d mocked up in a brochure. Here over 50% of householders who’d displayed the smaller sign agreed to display the larger sign compared to less than 20%  in the ‘control group’ of householders who were not first approached to display the smaller sign. That’s a big change in average behaviour from a small public commitment.

The power of public commitment can be a useful aide when trying to do more exercise or give up smoking. However when it comes to the complex and rapidly changing environment of investing being fixed in one’s opinion is rarely good. Once we publically take a position, like a positive write-up of a company on a website, it becomes much harder not to commit further by buying shares or increasing a position. And much harder to sell a position for which we’d previously made positive public statements.

I sometimes I find this effect even manifests itself in the amount of research I do. The more I research a company the more I want to appear consistent to myself that the hours of work are worth it, the more likely I am to find justifications why this is a good buy (or sell) and more likely to take a position. Then given the amount of research done I’m more likely to share this publically and compound the effect.

And the most worrying thing about the ‘consistency’ effect is that we may be completely unaware of its influence on us. The same researchers who did the initial experiment with the 'drive carefully' sign repeated it but rather than using the small sign as the initial influencing factor they asked residents to sign a petition agreeing with ‘keeping California beautiful.’ Surprisingly this, effectively nonsense petition, had the same effect as the small sign in activating the residents’ sense of civic duty and led them to accept the large ‘drive carefully’ sign in almost a similar proportion. But more assiduously, whereas maybe some of the participants in the initial study may have thought ‘hang on a minute, I’m only accepting this large sign because I accepted the small one two weeks ago’ in this case I would imagine very few people made the link between accepting the large sign and the petition they signed a few weeks ago. Yet the evidence is that it was a significant influencing factor for many of them.

Sharing research and investment ideas can be a key part of getting feedback and improving your investment skills as well as being part of an active part of an online community. However next time you make a public statement about the investment merits of a particular share it’s worth thinking in advance of what events would cause you to change your mind and sell (or cover a short.) Even better write them down, so you have made a public commitment to yourself to change your mind if the facts change and you’ll at least want to appear consistent to yourself with that.

Monday, 17 August 2015

The Dividend Fallacy

The dividend fallacy usually goes something like this:

“Reinvested dividends make up the bulk of long-term equity returns. Therefore you should invest in high yield shares.”

For obvious reasons the fallacy is most prevalent amongst those private investors or fund managers who practice high yield or income investing.

Let’s see where this argument goes wrong:

Fallacy 1 - Reinvested dividends make up the bulk of long-term equity returns.

This usually comes from studies comparing the market returns with and without re-invested dividends. E.g.

“One hundred pounds invested in equities at the end of 1899 would be worth just £168 in real terms without the reinvestment of dividend income, but with reinvestment the portfolio would have grown to £24,184.” Barclays Equity Gilt Study 2013

Of course these are not comparing like with like. In the first case you would have had the dividends in your pocket to spend or invest in other assets. In fact if you had another asset class that produced superior long term returns to equities and re-invested your dividends there you would have more money than £24,184. The reason that the comparison is so striking is that equities have been pretty much the best performing asset class to re-invest into (at least in most western countries.)

When you breakdown the Barclays return figures together with their cost of living index into compound annual growth rates they look something like this:

Real Return with Reinvested Dividends                                  5.0%    (A)
Inflation Average                                                                      3 .9%   (B)
Nominal return with Reinvested Dividends                              8.9%    (A) + (B)
Real Capital Return                                                                 0.5%    (C)
Nominal Capital Return without Re-invested Dividends         4.4%    (B) + (C)
From which you deduce the Average Dividend Yield was      4.5%.   (A) – (C)

People then erroneously compare the dividend yield to the real capital return and conclude that re-invested dividends are the major source of return. This comparison artificially separates out the components of compound growth and arbitrarily to applies the compound inflation to the compound capital gains. The re-invested dividends are done so at the nominal price of the index at the time so are subsequently compounded at the nominal rate not the real rate. Simply reversing the logic and applying the inflation to income would show that reinvesting dividends in a market without capital growth would lead to very low real returns and therefore capital gains were the driver of the bulk of returns.

The truth is that both dividends and capital gains are roughly equal in their contribution to equity returns at 4.4% for capital and 4.5% for income. The real return an investor receives is then reduced by inflation that has averaged 3.9% since 1899. This should hardly come as a surprise since the dividend payout ratio has been close to an average of 50% during the last century.

Fallacy 2 - Therefore you should invest in high yield shares.

The second fallacy is assuming that the impact of re-invested dividends on the returns of the whole market says anything about the performance of high vs. low yield shares within that market. To make statements about the relative performance of subsets of the equity markets you need empirical evidence.

In ‘Contrarian Investment Strategies’ David Dremen did these studies for the largest 1500 companies in the US Compustat database from 1970 to 1996 and the results are as follows:

The market total return was 15.1% CAGR over that period. So you can see that sorting by dividend yield does provide out-performance but it is the weakest of the metrics studied. If you want to implement a simple factor based strategy then you are better off using one of the others.

Dividends Redeemed

So you may be thinking that I don’t like dividends. Far from it. Used correctly I think dividends can have an important part to play in one’s investment strategy:

  • Paying a dividend enforces capital discipline on management. Since management know the impact that a dividend cut will have on their share price (and therefore the value of their options) then they really need to make sure the business earns the cash to pay it. They are less incentivised to pursue vanity acquisitions or take unnecessary investment risks.

  • Dividends provide effective signalling of the true opinion of management. A management that provide a cautious outlook but a big dividend increase are usually practicing ‘under-promise & over-deliver’. A management that talk up the company results but hold the dividend could well be ‘travelling hopefully.’ 

Here’s an example of this signalling. In March 2009 a UK company called Interserve (LSE:IRV) issued their 2008 results with the following management commentary:

"2008 was another successful year for Interserve. Whilst the Group is not immune to the current economic challenges, with a solid UK position, continued opportunities in the Middle East, a record order book, strong visibility and a robust balance sheet we believe that the Group's operations are well placed to deliver another year of progress." 

Having traded around the £5 level in March 2008 the shares were trading at around £2 when these results were released and the failure of Lehman Brothers had rocked the financial markets and the Western economies were in a deep recession. Given the uncertainty in the markets and that they were trading at a historic yield of 8.1% no investor would have been disappointed if Interserve had preserved cash and held their final dividend. However they chose to back their cautiously optimistic statement by increasing their dividend by 4.9% giving an 8.5% yield. I took this as a strong signal that things were not as bad as the market feared. This proved to be correct as they continued to increase their dividend and led to substantial gains over the next few years.

  • Focussing on income and not capital value can instil a very long investment timeframe in investors. Having a longer investment horizon is one of the only true competitive advantages that private investors have so this can add significant value to one’s decision-making. Even within fund management, income funds can be a good choice for those who don’t have the time and skills to invest directly. The reason is that these funds are also likely to be long-term focussed, attract long-term investors and avoid high fees or closet index-tracking. I.e. they simply make fewer mistakes than the average fund manager.

So used correctly dividends can be an important part of an investor's tool-kit. They provide a measure of management quality, a strong indication of the true performance of the business and a check on our behavioural biases. But only if we leave behind the dogma that reinvested dividends make up the bulk of long-term equity returns and that this makes dividend strategies fundamentally superior to all others.

Tuesday, 11 August 2015

Portfolio Construction - Holding Too Much Cash?

In part two of my series on improving portfolio construction I raised the issue of why would you hold any asset that has a low return. The corollary of this is that why would you hold significant portion of your assets in the low risk but low return cash?

The average private investor holds quite a lot of cash. The AAII asset allocation survey puts the average at 24% over the last 30 years. Given that the average equity fund held just 3.5% in cash and both equities & bonds have outperformed cash over most long periods Cullen Roche makes the argument that this is one of the main reasons that private investors underperform their professional equivalents:

Now a sensible investor will of course have cash holdings for any short and medium-term expenses and will only invest long-term in the stock market. However the AAII survey is looking at investors dealing accounts so this is primarily cash that is looking for an investment home but not found one.

So why do private investors tend to hold so much cash? Cullen Roche suggests that this is short-term thinking with investors (over-) valuing the certainty of large cash holdings. While I’m sure this is true I think there is a subtler effect at play here as well. When you ask investors why they hold cash it is usually to take advantage of market weakness.

We feel clever when the market sells off and we are holding a lot of cash and dumb when we are fully invested!

While the aim is laudable we pay a high price for this feeling. The problem is that the average investor is very bad at calling the short time direction of the market. They spot too many crises and sell up too often. A problem originating from our history as hunter-gatherers. If you spotted an imaginary tiger in the jungle and ran away the consequences were a bit of unnecessary spent energy. However if you failed to spot a real tiger the consequences for you would be very severe. Hence we tend to see tigers in the market far more often than they actually appear.

Then compounding this error we succumb to fear and fail to actually buy on real market weakness. A number of investors spotted the 2008 financial crisis, realised its severity, and sold all their equities. However it's a much smaller number who then spotted that the market was historically cheap in the spring of 2009 and reinvested. There are many who missed out on the early rises and never got back in. Given that the FTSE total return index has returned c.40% since end of 2007 and cash has paid virtually zero in this time even these most prescient of investors may have been better off simply remaining fully invested.

I think the only time that one should hold a significant proportion of cash is when one cannot find any investments that are potentially undervalued with a margin of safety. Given the cyclical nature of the most industries and market sectors it is rare to find a time that the overall market valuation provides no scope for investment opportunities. I'm not saying that the indices are always a buy just that if you are a stock picker you should be deploying your capital into undervalued stocks not holding large amounts of cash hoping for a market crash.

And while having some cash on hand to take advantage of market weakness can be a good strategy it only works if you have the mental strength to deploy it when the market does sell off. So if you are holding a large amount of cash you should ask yourself if you have a good record of identifying when assets are over-priced? And do you have a good track record of actually deploying that capital quickly on market weakness? Unless you can answer both questions positively you may be better off simply remaining fully invested and heeding the old adage that it’s time in the market not timing the market that really pays off.

Saturday, 8 August 2015

Portfolio Construction Part 3 – Rule Your Portfolio

In my first two posts (Part 1 - Diversification, Diworsification?, Part 2 - The Matrix Revolution) I looked at how to determine the correct diversification level for your portfolio and a way to simply but optimally weight those assets. In the last part of this trilogy I will look at some simple rules that can help avoid behavioural biases creeping into our portfolios.

When you get to see the portfolios of most private investors they usually look something like this (based on a real world example from the web):

ABC 19.45%
BCD 12.37%
CDE 9.35%
DEF 6.58%
EFG 6.29%
FGH 5.97%
GHI 3.22%
HIJ 3.01%
IJK 2.90%
JKL 2.83%
KLM 2.74%
LMN 2.47%
NOP 2.45%
OPQ 2.20%
PQR 2.17%
QRS 2.12%
RST 1.95%
STU 1.89%
TUV 1.81%
UVW 1.49%
VWX 1.41%
XWY 1.14%
WYZ 1.12%
YZA 0.86%
ZAB 0.73%
CBA 0.64%
DCB 0.45%
EDC 0.39%

At 28 positions the diversification level is probably about right for an active stock-picker, however note the one or two large positions combined with a tail of very small positions

The Large Positions

Usually the large positions are the investor’s past big winners. I looked at asset weighting in part two and one of the key takeaways was that the largest positions should only be the investment ideas you believe to have the best return potential and the lowest risk. It is always worth re-evaluating your biggest positions to check that they really do match these criteria. Asking yourself the question ‘if I was forced to sell today would I seek to buy back in the same size as soon as possible?’ often helps understand if you have your position-sizing correct. Given the impact on your performance those largest positions will have it is worth setting aside a regular time to do this.

Employer Positions

The other common reason for people having a large holding as a percentage of portfolio is that they are the shares of their employer received through a share-save scheme or similar. I mentioned this briefly in part one. Sharesave or option schemes that allow one to own shares in one’s employer at a discount or without risk at the time of purchase can be a great deal. If you are a director of the company and can assess and influence the competitive strategy of the business it makes sense (and is often expected) to hold onto a significant proportion of these shares. However when you don’t have board level influence the shares should be treated just like any other investment. This means, for example, following the principles of portfolio weighting I discussed in part two. One of the risks I mentioned in that piece was correlation risk, the common exposure stocks have to factors that are out of your control. When it comes to your employer this risk is almost always large not because of the correlation with other stocks but the correlation with your salary. When your employer is performing and growing strongly you are more likely to get pay rises, bonuses or be promoted. Conversely when the business is struggling you are more likely to be made redundant. Your economic exposure to your employer is large whether you own shares or not. It pays to include this factor in your portfolio decision making process.

The Small Positions

The small positions usually have only one characteristic - they are the past losers. Once a shareholding is below a certain size it has very little influence on the future returns of your portfolio. A 0.5% holding would have to double to have the same influence as the normal daily noise movements of a 10% holding. So why do we end up with these holdings? I believe this is primarily loss aversion. We prefer the hope of a future gain no matter how unlikely or inconsequential to taking a definite loss today. One of my favourite examples of the loss aversion comes from the book ‘Beyond Fear & Greed’ by Hersh Schefrin summarised below:

Loss Aversion in a Real Estate Deal

Bill & his wife are in their early thirties and have just had their first child. A good friend, Jim, has been successful at investing in real estate deals for a few years suggests that they join him in his next deal. They put in all their $27.5k savings and borrow $75k to fund their half of a parcel of land which will be split into lots for housing and sold off, hopefully for a good return. Given the interest on the loan this investment is cash flow negative for Bill & his wife.

Some time passes and the land sales are not progressing as rapidly as Jim had hoped so he decides to put up a model home on the land. A year later the model home has been built and sold but has not generated more interest in the rest of the land. At this point James, feeling bad that he had got his friends into this, offers to take on their share of the deal. This would mean that Bill & his wife would lose their $27k but avoid any further losses from the loan financed on the land. Despite little experience of real estate investment and the real prospect of further cash outflows on the deal, being loss averse they declined the offer. Over the next few years James offered to buy them out but in each case they preferred the hope of a future gain to taking a definite loss today.

Now in the mean-time Bill became an elected official. At this point his future earning potential is so high that he shouldn’t rally care about $27.5k loss but being loss averse he does and allocates one of his aides to manage the real estate deal. Tragically that aide commits suicide and this leads to scrutiny of exactly what he was doing for Bill. At this point Bill is given a choice. He can accept a censure from Congress, essentially a slap on the wrist, or can agree to a wide ranging investigation into all his affairs. However the censure from Congress is a definite loss today. So being loss averse he prefers to risk the investigation. Unfortunately for him the wide-ranging investigation reveals that Bill is having a sexual relationship with an intern. Now at this point he can be honest, go on TV and beg forgiveness from his wife and constituents. However this would be a definite loss, so being loss averse he rolls the dice and prefers to gamble that they don’t have any evidence to back up the claim. So he goes on TV and says ‘ I did not have sexual relations with that woman.’ Of course we now know that President Clinton did have an affair with Monica Lewinsky, they did find evidence, and Bill was almost impeached as President of the United States. All because of loss aversion.

So the moral of the story is that if a man as successful & charismatic as Bill Clinton suffers from loss aversion so do you and me.

For this reason I have a rule. If a position drops below 1% of my portfolio and I’m not willing to add to the position to make it above 1% then I sell the whole position. If I don’t have the confidence to hold at least 1% this clearly isn’t my best investment idea. The small position size means that its potential impact is very low anyway so if it is still in my portfolio it is a sign that I am suffering from loss aversion. If I don’t clear out that long tail of losers they will take up emotional and mental energy that is best spent on my best ideas. Given the emotions that surround selling losers the 1% rule is surprisingly hard to implement but really worth doing.

The only case that I can see it being worth holding a very small number of shares is when you want to incentivise yourself to better understand a company. For some reason most investors are better at really kicking the tyres when they have some money on the line. This should not be an indefinite position though. You should set yourself a deadline at which point you assess the company and either add to the position or sell it. The downside to this strategy though is that ownership bias will probably make you rate the company more highly than you otherwise would. For this reason this should be used sparingly.


The other most common bias that impacts portfolios is ‘get-even-itis’. You probably have suffered from a case of this too. It starts when you have a position that goes against you. As it appears ‘red’ in your portfolio you start to worry. As it drops further you think ‘I wish I’d sold when I first started to worry.’ The worry stops increasing when it starts to bottoms out and starts to subside as it starts to rise. Then when it gets back to your buy price you are so relieved you immediately sell. This of course is a form of ‘anchoring’ and is illogical. If nothing has changed since you bought then the share price going down and up again has not changed the investment case. Equally if the investment case has deteriorated you should have sold immediately and it is merely chance that means you are back even. Again given the power of this effect it may be worth setting a rule that you never sell a share at your buy price. Particularly when the share price trajectory has been a drop and recovery on no news.

In Summary…

Given that behavioural biases are pervasive, hard to identify in real time and high impact it makes sense to have a strategy to deal with them. I believe the best solution is to create a sensible set of rules in advance, write them down, and apply them rigidly. This doesn’t mean you follow a purely rules based investment strategy but you proactively identify areas of weakness and think how applying a simple rule could overcome that. This frees you to spend your energy where you can have the greatest impact: finding great investments that no one else has spotted.

Wishing you all, correctly diversified, properly weighted portfolios free from behavioural bias.

Saturday, 1 August 2015

Portfolio Construction Part 2 – The Matrix Revolution

In my previous post I looked at the sort of factors you need to consider when deciding what level of diversification is right for you. In this post I’m going to look at a way of improving how you weight those assets within your portfolio.

There is actually a mathematical method for determining what proportion of one's portfolio you should allocate to certain investment opportunity. It's called Kelly criterion and is based on the expected return and the odds of receiving that return.

This can be shown mathematically to maximise one’s return over the long term. Unfortunately, although mathematically optimal, applying the Kelly criterion to portfolio construction has a few issues:
  1. It is based on a consecutive series of events which you can determine the odds and payoff for. It doesn’t generalize well to portfolio management where you are choosing between competing concurrent investment opportunities.
  2. Probably the biggest issue with applying the Kelly criterion is the level of draw-downs you can expect. These would be enough to end most investing careers if realised. For this reason even practitioners that use the Kelly criterion explicitly use a fraction of the amount that the Kelly criterion suggests.
  3. The final issue is that the Kelly criterion assumes that one can accurately assess the odds of success and the payoffs. If you get the odds wrong or have a large level of uncertainty (as is likely when investing in individual stocks) there is a big variation in what proportions you should apply.

So rather than give a specific mathematical formula I suggest the following simple framework based on similar principles to help you allocate assets or test your portfolio in a logical way.

The first principle is that you should hold more of stocks that you believe to have the greatest upside.

It is perfectly valid to have a portfolio where you believe a set of stocks as a group to be fundamentally undervalued but you are not able to determine any difference in potential between them. This would be akin to a simple quant strategy e.g. buying the cheapest decile of stocks. In this case it makes sense to equal weight your portfolio. However for the rest of this post I’m going to assume that there is an ability to at least roughly assess the potential upside of a company and that you want to make the most of that potential upside.

The second principle is that you would like to bear the least amount of risk in achieving that upside.

Now when I say risk here I do not mean, as academics often do, just volatility or the co-variance of price movements. These can matter to investors. Particularly professional money managers who bear career or asset flow risk during periods of low returns. Or the private investor who bears ‘volatitility risk’ by explaining to a spouse why they are going to Blackpool on holiday this year not Barbados! However these are not the only forms of risk. What I am talking about here is an honest assessment potential downside if things go wrong or the risk of a permanent loss of capital. Forms of risk on top of volatility one may want to account for are:

Financing risk – Companies with high levels of debt will be less able to weather a period of poor trading. A heavily loss making company may struggle to raise extra capital.

Management risk – Management with a history of poor capital allocation may not act in the best interests of shareholders.

Product risk – Companies with one product or a few products serving only one market are more exposed to the performance of that product or market. Typically, but not exclusively, this makes smaller companies riskier.

Liquidity risk – The risk of not being able to sell near the published price when you want to. Typically, but not exclusively, this makes smaller companies riskier.

Commodity risk – Companies without a sustainable competitive advantage to control pricing are more likely to be exposed to commodity, economic growth, inflation or obsolescence factors.

Correlation Risk – I don’t mean the mathematical co-variance of stocks but the common exposure they have to factors that are out of your control. For example if you already have an oil explorer in your portfolio adding a second one should be considered higher risk (all other things being equal) than adding an equally undervalued oil consumer such as a plastics manufacturer.

By assessing the stocks in your portfolio & watch-list on these principles you can then use the following matrix to determine portfolio weightings:

  • If you find investments that are both low risk and high potential return then you should invest heavily in these.
  • For low risk investments with a good return potential or slightly riskier stocks with an excellent expected return you can hold a reasonable amount.
  • If you find very high return stocks that are also risky and a conservative assessment of the expected return is positive you should invest. It’s just that you should limit yourself to small positions in these types of opportunities. If they come off the returns will be high even from modest positions.
  • Finally why would you choose to hold any investment if it’s going to generate a low return whatever the risk level?

The precise percentage values will vary depending on your chose diversification level (see Part 1) and the availability of good investment ideas however these sorts of levels tend to work for me with a typical 25 long positions:

If this seems simple to you it is because it is. And if we all invested our capital fresh every day we would probably naturally gravitate towards something like this. However typical portfolios evolve over time. Capital is added or removed at different times. Stock prices change and with them our portfolio weightings. Because we all suffer from anchoring effects and ownership bias our portfolios can quickly vary from the ideal without us taking action. Therefore the real power of applying this framework is being able to assess your current portfolio against it. Too often we buy a high risk position that goes up significantly and becomes a large position. Typically this then has same or increased downside risk but reduced upside as its valuation becomes stretched yet it has become one of our biggest positions. Often we hold on without selling as it becomes a small position weight again! Conversely when we really have found a low risk investment with a very high return we may fail to put enough into it to really take advantage.

One of the common objections to rebalancing portfolios is ‘I like to run my winners and cut my losers.’ However this only works as a strategy because share prices exhibit medium term positive serial correlation i.e. they have momentum. And you’ll notice that I’ve specifically not mentioned valuation in my assessment of potential upside. As a value investor my primary method for assessing potential upside is valuation metrics however yours may be something different like technicals. Whatever your method the matrix still gives a good logical framework for asset allocation. There is good academic for momentum i.e. that prices that have risen for 6-12 months tend to keep on rising therefore it can be right to include the price momentum in determining the potential upside. Just that one should be consciously doing this and if that is the primary component of upside that remains one needs to sell when momentum fades. Like all other forms of excess return it requires disciplined execution to capture effectively.

For advanced investors you can expand the matrix to include shorting high risk stocks that have low expected returns. And the high risk but very high return potential of options strategies.

But like all complex investing strategies they should be used cautiously with small diversified positions and only after getting the basics right.

So in summary, good position sizing can seem less exciting than choosing your next winning stock however it is equally important to acheiving consistently good returns. It makes sense to apply the principles that you want to maximize your upside and minimize your downside to all your portfolio positions. I believe that creating your own risk-reward matrix, and consciously assessing your portfolio against this, will provide a framework that will keep you in line with these over time and lead to better long term returns.

In the last part of this trilogy I will look at some simple rules that can help avoid other behavioral biases creeping into our portfolios.