Risk Ratio & Asset Allocation

Continuing on our recent theme of structuring and building stock and alternative investment portfolios, I wanted to share a few thoughts on how risk ratios play into asset allocation.

When assessing any opportunity, it’s important to look at the best and worst case scenario, at least taken to a reasonable degree, then compare the potential gains versus the potential losses to get a risk ratio. Defining the downside is relatively easy stocks by setting stop losses set at a reasonable amount below the investment value.

In alternative investments, it’s not quite as easy as setting a stop loss sell price. To start, there’s the problem of valuing alternative assets. Values can only be considered estimates until a sale occurs, as prices often can fluctuate significantly in private asset sales. That leads to the second problem of a limited market of buyers for alternative assets. Alternative assets are decidedly less liquid than stocks, so when considering the worst case scenario, you need to consider the actual value if you needed to liquidate for cash within a reasonable amount of time. That time changes based on cashflow requirements, type of asset, and other variables that can be assessed on a case by case basis.

The upside is a relative guess for both stocks and alternative investments, though assets like real estate are typically much easier to estimate than a single stock or a single angel investment. In all cases, it’s important to come up with a reasonable estimate of the target value, should everything go right.

From there, it’s easy to get a risk ratio by dividing the potential gain by the potential loss. A high risk ratio means there’s more upside and implies the likelihood is decreased. While true, it’s important to account for how much capital is at stake and know how often you need to be right in order to win.

Working through these numbers before making an investment can help visualize how the investment plays into your portfolio, in terms of capital at stake, the worst/best case scenarios.

For our own investments, we set our numbers at the initial time of investment, then reassess occasionally by updating the target price, market/estimated value, low value, etc in a spreadsheet, based on any new information/developments. By using the spreadsheet, we get a chance to quickly reassess each investment and see how our assumptions affect our portfolio as a whole, potentially triggering other changes, including changes to our asset allocation.

NOTES:

Our own spreadsheet is based on Chris Perruna’s spreadsheets, which he included in a post on Position Sizing & Expectancy. Give that a read for more info.

We’re working on updating our portfolio tracking spreadsheet to work with a combination of stocks, crypto, and alternative investments. We’ll share a template when complete.

Building a Stock Market Portfolio by Theme

Even with alternative investing in mind, many investors, including ourselves, keep some amount of capital in public market investments. There’s potential for considerable upside, though typically less than alternative investments. There’s no control of the investment, both in the sense that you can’t control the company’s performance nor how the market reacts, which may or not be in line with the company’s performance.  Though the higher liquidity is nice both as a piece of mind and potential to get out of bad investments quickly.

There’s a number of ways to go about constructing a portfolio. From a basic perspective that including roboadvisors, human advisors, handpicking index funds, and handpicking individual stocks. Of course, it’s also possible to use some combination of these styles.

Personally, I’m not a big fan of losing control of where my money goes, such as the case with index funds. There are a number of companies with which I’d prefer not to be associated with, either for business or personal reasons, so I’d rather handpick individual companies, much like I do with individual alternative investments. In some cases, this isn’t feasible due to a lack of knowledge of individual businesses or difficulty in investing in specific businesses.

Actively selecting individual securities is a mostly outdated style, though the tools and info make it easier than ever to be informed and to act (buy/sell). For us, it’s about investing in good companies in trending areas ripe for growth. The themes were following for 2018 include:

  • fintech – technology is completely changing finance. this includes roboadvisors but is much more than that including payments, funding, etc.
  • crypto – it may be a bubble yet that could still grow significantly before it pops. regardless, there’s new technology and it will have major implications. many existing public companies are already involved.
  • marijuana – things may be volatile in the U.S. under Trump/Sessions. Still seems inevitable at some point in future that this will be federally legal. For now, Canada offers some options as it’s scheduled to be federally legal there in july.
  • ecommerce – this has grown every quarter for over 13 years as a percentage of total retail sales. amazon is the leader, still growing but largely outside of retail. more and more business is done online.
  • automation – things are getting automated, jobs are changing. it’s inevitable. companies that take advantage of this will will.
  • cyber security – more attacks likely in the coming years. security becoming a bigger concern to companies. more resources being allocated to security.
  • technology – there’s a general pro-technology consumer market that wants the next device constantly. this may not always be the case but for now people willing to give significant resources (time, money) to technology. recently, there’s been some pullback in terms of news stories, but usage and spending hasn’t diminished at all.
  • non-meat foods – includes organic produce, healthy grains, and meat-replacement solutions
  • pro-women – companies that are very pro-women will benefit from both publicizing their message and making their organization very fair and open
  • china – huge and growing middle class market.

The next step is to find companies working in these themes. They may not be 100% focused, but should a leader in that area, giving them room for substantial growth as the market grows. We’ll look more at individual selections in a later post.