What Football Can Teach About The Art Of Portfolio Construction

13th Oct '14 by Edward Croft

8 comments 11544 reads

So I'm sitting down to watch the first match of the Brazilian world cup and I realise that my 7 year old son knows the name of every single player on the pitch. Not only that but he knows their positions and their shirt numbers too. Now I'm not totally ignorant on football matters, but his depth and understanding of the game astounded me. I've kicked plenty of footballs in the garden, but I couldn't remember force feeding his memory with this information. I could only presume he'd taken it all in by osmosis...

Children have always been bathed in team sport culture, from the playground and games fields of yore, to the video games, apps and TV of today. If you ask anyone to construct a football team, even if they don't know any players, they'll likely understand the rudiments of attack and defense - it's in their very fibre. You'd need a goalkeeper, defenders, midfielders, and strikers... 4-4-2... a balance between safety at the back, playmakers in the middle and firebrand talent at the front. It might be hard to make a unit gel, but there's barely anyone who'd stick a striker in goal.

From footie to folios...

Given our grounding in team sports, I often wonder why investors seem to have so little clue about portfolio construction & diversification. A standout research paper by Kumar and Goetzmann in the 1990s studied the diversification and investment results of 60,000 individual investor accounts at a retail brokerage. Astonishingly they found an average holding of about 4 stocks per portfolio, mostly all held in the same sector. That's the investing equivalent of starting a football match with just a handful of strikers and hoping to get lucky.

Football teams and portfolios really aren't all that dissimilar, but the way the game is played is. Rather than charging at you head on, the market lulls you into a false sense of security, teasing you into feeling comfortable playing with just a handful of players... letting you strike a few goals, letting you take and defend a lead... only to snap back and counter attack months or years later, right at the moment you've grown most complacent.

It's the slow tempo of the stock market game that encourages too much risk taking and a poor selection of players. Structuring your portfolio to protect against delayed consequences is mission critical in stock markets, and it starts with giving…

Unlock with Email

Unlock with Google

Already have an account?
Login here

Sully8786

13th Oct '14

Hi Ed,

It's an interesting piece. My one problem is this:

If we take my portfolio as an example, I have 30.7% in financials. We can break this down further:

Amati VCT Closed Fund (LON:ATI), Elderstreet VCT (LON:EDV) and Edge Performance Vct I Shs 10P Closed Fund (LON:EDGI) are all VCTs, Cenkos Securities (LON:CNKS) and S&U (LON:SUS), yep, I'm happy that they are financials. I then look at Berkeley Group (LON:BKG), wait, Berkeley Group (LON:BKG). Is that a financial stock?? Is Optimal Payments (LON:OPAY) an industrial stock??
My point being, the information would be useful if the stocks were in appropriate sectors, as it stands, there doesn't seem to be any rhyme or reason as to how stocks get put where.....although, it would be nice to see a barge pole sector for Paul Scott's report :)

Regards,

Sully.

emptyend

Interesting thoughts.

I'm tempted to add that it is a game of two halves...... ;-)

I'd also note that it is possible to win by having all the possession (as Barcelona do, for example) or by having very little possession and counterattacking (as Crystal Palace have done in 2014, letting the opposition have the ball for 2/3 of the match)

It is also possible to win at football by outscoring the opposition (great attacking skill compensating for defensive frailty - eg Holloway's Blackpool or Keegan's Newcastle) or by keeping it very tight at the back and winning lots of games 1-0 (Graham's Arsenal or most Chelsea sides ;-)).

So, whilst it is true that the game is usually played by those who have a balanced team and tactical approach, it doesn't mean that this is the only way to succeed.....

....and in that sense football is indeed quite a good model. Most people play the conventional, balanced portfolio, traditional way - but a few people don't.

Perhaps football and portfolio construction are simply bell-curves?

Edward Croft

14th Oct '14

It is of course essential to have quality substitutes in reserve. Given the need for fresh legs, you'd be a pretty daft manager to put tired players on the bench.

brucepackard

I disagree, there is a lot of evidence to suggest running a concentrated portfolio of companies with sustainable competitive advantage and high ROIC leads to far superior investing performance. Just because the economics profession hasn't worked this out yet, doesn't mean it is untrue. See

http://www.amazon.co.uk/Warren-Buffett-Portfolio-Mastering-Investment-ebook/dp/B001GXQOJ6/ref=sr_1_1?ie=UTF8&qid=1413273809&sr=8-1&keywords=the+warren+buffet+portfolio

http://www.amazon.co.uk/Fortunes-Formula-Scientific-Betting-Casinos/dp/0809045990/ref=sr_1_1?ie=UTF8&qid=1413273847&sr=8-1&keywords=fortune%27s+formula

Alternatively - if you do believe in portfolio diversification, use Gerd Gigerenzer's 1/N diversification rule.

http://www.psyfitec.com/2014/05/the-turkey-illusion-audience-with-gerd.html

Hi Bruce, I've read both those books several times... and they both hinge quite heavily on the use of the Kelly Formula. For those who don't know the kelly formula - it's the optimal sizing strategy for your bets IF you know both the odds you are being given on the bet AND your edge. The problem in investing is that most investors neither know the odds, nor their edge, so I think the bandying around of this formula in investment books is immensely dangerous to private investors.

The Kelly Formula notoriously puts investors into massively oversized positions. Sensible investors who do know their edge and odds either use the half-Kelly or third-Kelly position sizing. The only people I know who do this successfully have massive research teams behind them.

There are many naive measures of company quality that are overused by the finance profession to highlight quality stocks - ROE, ROCE, Margins etc - but notoriously these measures are NOT valid predictors of stock market returns - they are merely descriptive of current company profitability. Current profitability is generally extremely well priced by the stock market and leaves nothing on the table - see O'Shaughnessy's What Works on Wall St or any other book that tracks the performance of these things.

There's a friend of mine here in Oxford who runs a hedge fund that specifically hunts for companies which have high current profitability according to these kinds of naive measures and bets against them. He makes 15% annualised. Quality stocks seeing nasty shocks right now include Mulberry down 20% today on profit warning, Xaar etc etc... we are seeing the reaper return to do his work.

My worry is that private investors end up listening too closely to books like the ones you mention, and use naive measures of profitability to compose 'conviction' portfolios, but end up in under-performing, high volatility (stress) portfolios as a result. They may do really well - but is that down to skill rather than luck ?

Personally - I used to invest in precisely the way described - 5-8 stock conviction portfolios, but I've mellowed with age and experience... I'd rather invest in a systematic fashion and harvest the premiums available in the market with broader diversification... the stocks to me don't matter so much these days, but the fundamental profiles of the stocks do (good, cheap, improving etc). And you can always use prudent leverage if you want to chase returns. As Cliff Asness - of the giant hedge fund AQR Capital said...

We simply believe, in moderation, leverage is a better risk to take in pursuit of higher returns than is the risk of concentration.

And of course, contrary to what Hagstrom might have written, Buffett made much of his additional returns in his golden years through leverage rather than concentration.

Fair enough Ed. I agree that it is hard to find companies with high and sustainable returns - they are a rara avis in terris nigroque simillima cygno.

But I'm also frustrated that there isn't more debate about diversification. It is often suggested diversification is self evidently less risky - which it isn't.

For instance pre-credit crisis large banks claimed that they were low risk, because they were so diversified. But having £1.9 trillion of assets and £50bn of equity funding (as RBS did) was not a low risk business. In contrast taking a large position in one company (say) Unilever 40 years ago, would have beaten most diversified investment strategies with less chance of losing money (which is how I define risk).

Alex Ferguson didn't follow that philosophy. "Super-subs" like Solksjaer and Beckham were used to very good effect in the dying minutes, even though the latter was hardly "fresh legs"....

What football can teach about the art of portfolio construction

From footie to folios...

Unlock the rest of this article with a 14 day trial

About the Author

Edward Croft

8 comments

Unlock the metrics for all these stocks and more...

Unlock the metrics for all these stocks and more...