Here is Part 3 on the wonderfully insightful interview in Steve Drobny’s book The Invisible Hands with Jim Leitner, who runs Falcon Investment Management, and was previously a member of Yale Endowment’s Investment Committee.
Leitner is an investor who has spent considerable time contemplating the science and art of investing, making money opportunistically across all asset classes, unconstrained, focused on finding the right price and structure, not losing money…and remaining humble (an increasingly rare quality in our industry).
His very clearly articulated thoughts about hedging, risk management, cash, and a number of other topics are profound. Below is Part 3 of a summary of those thoughts (please also see Part 1 and Part 2). I would highly recommend the reading of the actual chapter in its entirety.
Definition of Investing
“Investing is the art and science of extracting risk premia from financial markets over time.”
Risk, Preservation of Capital, Volatility
The risk management process starts with what you buy and how you structure those “themes and trades.” Jim manages his portfolio with a particular focus on the downside, where he “never wants to lose more than 20 percent and structures his portfolio to make sure that under no possible scenario can he ever exceed this loss threshold.”
People have a tendency to spend “more time thinking about returns than about how to manage downside risk. The investment process seems to be driven by a need to generate certain returns rather than a need to avoid absolute levels of loss on deployed capital.”
Jim gives a number of reasons why it’s important to preserve capital and limit downside volatility.
- Psychological – the emotional damage and potential impact on decision making, associated with large losses even if they’re unrealized or not permanent. He talks about not being willing to lose more than 10% in any given month, no more than 20% in any given year – these figures were determined based on personal “psychological recognition.”
- Career Risk – investors and bosses may not care that your losses are unrealized or not permanent
- Negative Compounding – After a drawdown, the law of mathematics makes it an uphill battle to get back to even. For example, when an investor is down 40%, it means he/she would need to make 67% to breakeven. This doesn’t account for any cash outflows/redemptions, which makes it even more difficult to get back to breakeven $ wise.
“While I am not sure what my focus on truncating downside risk has cost me over time in terms of lost opportunity, I am certain that I have not maximized return. But at least I can be sure that I will be around for future opportunities.”
Diversification
As a part of his process, he tries to identify crowded trades, securities, assets, “even portfolio approaches” because “…diversification only works when you have assets which are valued differently…If everything is expensive, everything will go down, so it doesn’t really matter if you own different things for diversification’s sake.”
Lesson from 2007-2008: “At the beginning of this period, all risk assets were no longer cheap. There was no real diversification in owning a portfolio of overvalued assets. This is the true lesson. Overvaluation becomes a risk factor that must be addressed directly in portfolio construction.”