Trading trade-offs

This is about the other side of luck. In spite of heroic track records and ingenious investment processes, it is gruesomely difficult to distinguish between a skillful investment manager and a lucky one. But let’s pretend for the duration of this entry.

So you think you can pick stocks. Or you have the ability to forecast returns in general. Before executing the best possible trade to exploit your forecast, you will have to balance the trade-off among at least three other considerations next to skill: aggressiveness, breadth, and correlation.

Return in the end is the only thing that matters, but it is portfolio return that matters: i.e. risk and in particular correlation matter too. I don’t mean, of course, correlation in the sense of a specific linear relationship among sample means of long-term historical data. The idea is that, loosely defined, investments – and investors – can be interdependent in many ways. The one’s behaviour in some scenario can be informative of the other’s. Both can be sensitive to similar catalyst events. They may even look like cause and effect.

A wider coverage of candidate investment strategies potentially makes for a richer correlation structure. It offers additional degrees of freedom to optimise risk-adjusted portfolio performance, which naively maximising absolute return over individual strategies would not efficiently exploit.

Secondly: every additional forecasting opportunity represents a chance to add value. More frequent positioning, shorter-horizon bets – in other words: more breadth – provides more opportunities to show or hone skill.

The third consideration involves the degree of confidence in skill or, inversely, the aversion to risk. More aggressive positions putting more money at stake will leverage profit – or loss.

But there is a catch. Active management comes with trade-offs. More breadth may mean more diversified bets that could allow you to be more aggressive. But more breadth could at the same time imply that the alleged forecasting skill is spread too thin and make you more hesitant to take on risk.

What will you do?

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