Allocation under modern portfolio theory and some value investing lessons to apply

Underlying the basics of the modern portfolio theory risk is perceived as the standard deviation of the asset’s price in the market. However, this is entirely different when saw from the value investing perspective. A value investor considers risk as a permanent loss of capital while, under the modern portfolio approach, the assumption is that investors are risk-averse and therefore need to be compensated with a reasonable premium for each extra unit of risk they take.

Let’s say an asset has a 10% mean return; nonetheless, the stream of return is not constant because it varies from month to month and fluctuates with a standard deviation of 5%. A modern portfolio approach would try to optimize or, to say better, judge performance relative to risk. This means that if you have a return of 10% but a 5% standard deviation, your risk/return ratio would be 2. Consequently, the modern approach is basically a mathematical model that defines risk as to the standard deviation and judges the stock from how it fits the portfolio and its risk/reward ratio.

A value investor does not approach risk in the same matter. In value investing, risk is defined by the health of the balance sheet, not from the beta of the stock. For instance, a value stock, which is usually a depressed one, has a potential theoretical drawdown of 50%. There is no intention from a value investing perspective in trying to time a better entrance on the stock. A value approach would analyze the stock making a single bet in a concentration of a few stocks without studying the impact of the volatility of the single bet on its own overall basket of stocks.

The latter is impossible for a modern portfolio theory trader or fund manager. They need to understand the risk/reward ratio of the stock and how it would impact the portfolio. Therefore, decisions are not taken on the stock’s quality only but on how it affects the overall position. So you could end up adding assets to your portfolio, not because you believe in the potential of appreciation but for the sole reason that the investment could have a negative covariance on the portfolio and stabilize the overall position. Or maybe because it could reduce the volatility of the portfolio without affecting the expected returns, which should indeed be the purpose of optimal asset allocation.

So buying a stock can have different meanings and purposes depending on your approach style.

If we would be robots, we could theoretically adsorb a drawdown of 50% without even blinking and adding a position to average down cheaper stocks. I try to do that, and I am among a few who are able to absorb such pressure without panicking.

The majority of investors cannot do it that way, they panic and sell when stock prices decrease to reduce what they call risk, and they try to cash momentum buying higher when the portfolio is green. I never buy on a good day or sell on a bad one. I try to do the opposite. Investors are moved by fear. When they experience significant drawdown, they illogically tend to sell at a lower price.

The only way you have to avoid that is to be confident about the stocks you own. Behind that confidence, there should be knowledge and conviction of your investments. A deep understanding of what you own is the only energy that can help you beat stupidity and indefinitely hold a “falling” asset.

When applying modern portfolio theory, hedging would help an anxious investor to navigate through volatile times. I had seen many investors breaking down in volatile times, even when they did swear to hold. I saw them literally in tears quickly selling because they were afraid to lose it all. Selling when stock presents less risk (because it is cheaper) due to the general market condition is silly. But it does happen every day, not only to amateurs but to professionals.

Before choosing your investment style, try to think about what is adequate for your stomach. The stomach is what you need in a difficult moment to adopt a particular investment style and being successful at it. To have the stomach is more important than technical knowledge, but technical expertise gives you the stomach to handle those difficult times.

As you build your portfolio, you must know your risk sensibility and, of course, your concept of risk before anything else. A simple approach to portfolio construction thought for weak stomach investors is the “All Wheatear Portfolio,” made famous by Ray Dalio. I love Ray Dalio, I love his philosophy, and I like him as a person. I believe he is honest, and I learned a lot from him on macroeconomics and how the economy works. But the All Wheater Portfolio is for people who want to have peace fo mind, even though I don’t think it did very well under the recent crises.

The “All Weather Portfolio” could work for me when I get to my 70’s. It assumes that you don’t know what is going to happen, and you have a portfolio that could perform or preserve your wealth in all scenarios: deflation, inflation, recessions, and so on. Another issue with Dalio’s approach is that Bond, which was used as a negative covariance to balance the risk of stocks, now would have a different meaning under the current monetary policy.

What Dalio does is to mix all the assets trying to move the weights of such investments in a way that fits its biases towards a particular macroeconomic view. Then if it is not right, it does not take a big hit. Still, if he is correct, then it makes money but not with the impact that it would make if he would go all-in on a particular asset.

Lets’ be clear and pragmatic; this means that you can do 7% to 8% a year if your biases are centered because your view would allow an asset allocation to favor a particular scenario. Or to make 4% to 5% when your preferences are wrong, but you will never experience a drawdown.

This is great for Mama and Papa or anybody that does not have enough stomach. I prefer to get richer or die trying, but I can stomach the drawdown. I want to deeply study the market, generate a firm conviction towards a macroenvironment or stocks, and chase my 100-million dream. I am not that far away anyway, and I would not embrace mediocrity for the sake of fear, don’t do the same, but I am this way.

I don’t invest what is needed to live but to make me jump to another level. I am searching for greatness, so I need to make something spectacular out of my portfolio. I will do what it takes and digest the drawdown as I have done until now because I am pretty sure the results will follow. I don’t believe in being cautions in periods of monetary loss policy unless the risk of systemic fall of the system and crack of the US dollar as reserve currency materialize.

The tail risk can be hedged not only by crypto but with assets allocated in emerging markets and alternative superpowers like China. The best hedge you can have is the ability to deeply understand what you own and keep studying your equity every day.

Value Investing is dead and is not worth pursuing, but some of its lessons are extremely valuable. We can take things from value investing, which would help us to understand the real meaning of risk and the foulness of selling your asset under the market’s pressure—the importance of a long-term perspective.

From the other side, trying to buy as a value investor does is foolish. To find a top-class business with a strong moat for a low price, based on its sustainable earnings and get free growth. Growth is that thing that makes it foolish and useless for any P/E calculation; price-earnings means nothing versus growth. If you grow exponentially, then what the point of price-earnings is?

In order to understand a company to insert it into your portfolio, you need to apply two elemental principles. The first is to understand that particular business, its potential, scalability, competition, and moats deeply. The second one is to know yourself.

Before you choose what kind of investor you are, understand what stomach you have towards volatility and if you can learn how to manage it with the knowledge of the assets you own. If you don’t have the stomach and the time, then embrace peace with a neutral All Wheater Portfolio. But don’t try to mix assets randomly without a proper plan, because that indeed can be the receipt for catastrophe. Know yourself and know your assets, have a plan before start playing.

About Antonio Velardo

Antonio Velardo is an experienced Italian Venture Capitalist and options trader. He is an early Bitcoin and Ethereum adopter and evangelist who has grown his passion and knowledge after pursuing the Blockchain Strategy Programme at Oxford University and a Master’s degree in Digital Currency at Nicosia University.

Velardo manages an 8-figure portfolio of his investment company with a team of analysts; he is a sort of FinTweet mentor, people interact with him online, and he has more than 40,000 followers after his tweets. He has built a fortune in the great tech years and put together a tail strategy during the pandemic that allowed him to take advantage of the market drop. “I did not time the market, and I did not think this was even a black sworn,” he says.

On the side of the financial markets, Velardo has a unique combination. He was a real estate entrepreneur that developed several projects in Tunisia, Miami, Italy, the UK, and many other countries and cities. But he has always been passionate about options trading. Still, contrary to the volatility player and quant trading, he always had a value investing touch in his blood. Antonio studied Value Investing at Buffet’s famous business school at Columbia University. Even though the central concepts of value investing are antagonists to the venture capital pillars, Antonio’s approach tries to bridge elements of both worlds in order to seek alpha. Velardo has learned the importance of spotting pure growth stories and taking advantage of their S-Curve position. This is an essential element of Velardo’s approach as he looks forward to embracing great tech stories at the right time of the adoption cycle. This applies to stocks but also to blockchain projects.