Risk – Part 1, Risk Taking

We run an internal concentrated equity portfolio and will always have a significant long bias for the simple reason that markets go up over time. We believe that if a country protects private property and allows its people to benefit from their hard work and creativity, then a stock market index that is reflective of the country’s underlying economy will trend higher over time. Despite this belief, we do not advocate for being fully invested at all times– no equity portfolio is immune from large market sell-offs.  Given markets are out-of-equilibrium systems prone to booms and busts, being fully invested is an inferior strategy to one that pares back risk when markets are fragile and takes more risk when markets are robust. Tactical shifts in risk-taking can help truncate downside portfolio moves in the event of a large market downswing while also helping to retain meaningful upside potential. This doesn’t just make our portfolio less volatile and more comfortable to hold, it enables us to have a higher terminal portfolio value at the end of a long investment horizon versus a similar portfolio that is 100% invested. In this paper, we describe the simple framework that guides our portfolio risk-taking approach. Part 1 will be dedicated to answering the question: How do we decide how much of our portfolio to put at risk and Part 2 will answer the question: After we decide how much risk we are taking, how do we manage this risk at the position level? (Note the crucial distinction between “risk-taking” and “risk management”).

How the Stock Market Behaves

This is a stylized image depicting the sinusoidal fractal-like behavior of markets. Of course, in the real world, there are no such things as smooth periods or ones that are measurable ex ante. The purpose of this image is to demonstrate the cyclical nature of fear and greed cycles around an intrinsic-value based uptrend. Fear spreads to a point where excessive fear gives way to greed and greed spreads to a point where excessive greed gives way to fear.

On a daily, monthly, and yearly basis, we continuously ask ourselves: Given the prevailing investment landscape, what portion of our portfolio should be at risk? While this might seem like a straightforward question, the investment landscape has been muddled by a plethora of financial products that promise enticing returns with minimal risk. Examples include Core Bonds, Hedging Strategies, Market Neutral, Long Short Equities, Risk Parity, among others. Furthermore, Modern Portfolio Theory provides a theoretical framework (that is built on false assumptions) to justify using backward-looking statistics to build a neatly weighted combination of the entire investable universe. This leaves investors staring at a portfolio containing a myriad of asset classes, funds, and positions– It is at about this point where we can safely say that they have long lost sight of the forest for the trees. They are left with a portfolio they don’t understand, the illusion of precision and a false sense of security about the risks they are taking. The only antidote is to have a correct and uncomplicated understanding of what part of your portfolio is at risk.

Our risk framework begins with a binary perspective that provides this simplicity. The investment universe is divided into two categories: Risk and risk-free. Risk introduces the potential for loss, and while countless ways exist to take investment risk, only two options offer zero investment risk: Cash and Treasury bills. Given this binary division of the investment universe, adjustment to our portfolio risk-taking allocation falls between two extremes, ~60% and ~125%. In other words, during periods devoid of opportunities, we allocate 40% of the portfolio to cash. This allocation offers protection in fragile market conditions and tactical liquidity during substantial downturns. Conversely, during periods of robust markets and opportunistic investment landscapes, we opt for modest leverage—about a quarter turn—enabling us to capitalize on favorable conditions. These extremes have been determined through empirical testing and theoretical exploration to strike the right balance between concave and convex risk-return profiles within a portfolio. Adjustments between the endpoints (60% and 125%) are influenced by our assessment of the two key pillars: Valuations and Fed policy. Our analysis of “risk factors” also plays an important role.  


Aswath Damodaran, a finance professor at the Stern School of Business and a contributor to valuation theory, likens valuation to “a life vest, a compass; it’s something for you to hold onto when everyone else is doing something different.” In this context, valuation refers to a firm’s intrinsic valuation, determined through the discounting of future cash flows. A full understanding of a company’s industry and competitive positioning are necessary to project cash flows and apply an appropriate discount rate. As investors, intrinsic valuations are our primary focus but also the most challenging to unearth. In a dream world with ample time, we would perform this analysis for every publicly traded company. Once we calculate intrinsic values for each company and compare it to its market price, we would then rank all names and select those with the highest discounts for our portfolio. If we can easily build a diversified portfolio of names with healthy discounts to intrinsic value, we will be fully invested (Figure B). The less we find stocks trading at discounts and the tighter these discounts (Figure A) the less we will want to be fully invested.


The above is a conceptual illustration and the diagonal line running through each graph is the efficient market line. Stocks above this line are trading at a premium and stocks below the line are trading at a discount.

Since we don’t live in a world where this exercise is possible, as a proxy for market opportunities we utilize insights from our bottom-up stock analyses which we believe is a representative sample of the larger economy. We buttress our bottom-up insights by utilizing broad market averages like price-to-earnings ratios and EV/EBITDA along with the prevailing level of interest rates. It is common to encounter stocks trading at 10x P/E that we wouldn’t pay 5x P/E for and, although far more uncommon, finding names trading at 15x P/E that we would happily pay 20x P/E for. Environments with healthy discounts in companies’ valuations and market multiples below ~15-18x are scenarios where we are more likely to be fully invested. Conversely, we reduce risk exposure when discounts are scarce, and market multiples are elevated.

The Fed

The Federal Reserve wields increasing influence over market behavior and the economy. Following the 2008 Global Financial Crisis and the 2020 COVID-19 pandemic, the Fed expanded its toolkit to combat crises, and both markets and Congress took notice of its effectiveness. The utilization of tools such as swap lines, quantitative easing (QE), credit easing outside the depository system, and shaping expectations reached unprecedented levels. The days when the Fed’s focus was primarily on manipulating the federal funds rate are long gone. The political pressure is now on the Fed to use its enhanced toolkit to fix anything that could potentially go wrong with the economy. Subsequently, market psychology has grown to love Fed intervention. The Fed has an outsized effect on liquidity and in the process of easing conditions, whether through lowering rates or expanding their balance sheet (QE), markets are likely to gain confidence causing us to be more likely to add risk. On the other hand, if the Fed is tightening conditions or removing liquidity from the system using QT, markets are likely to be more fragile causing us to be more likely to pare back risk. Legendary trader, Stanley Druckenmiller, sums this up in the quote below.

Contrary to what a lot of the financial press has stated, looking at the great bull markets of this century, the best environment for stocks is a very dull, slow economy that the Federal Reserve is trying to get going… Once an economy reaches a certain level of acceleration… the Fed is no longer with you… The Fed…..starts worrying about inflation and things getting too hot. So it tries to cool things off… shrinking liquidity

Given the Fed’s outsized influence will likely continue and even grow stronger for the foreseeable future, a thorough understanding of the Fed’s intent and the channels it is using to impart its influence is critical to our risk-taking.

Risk Factors

Where Valuations and Fed policy are a systematic study that helps detect the level of robustness in markets, risk factor analysis involves a more dynamic thought process that helps us to understand potential triggers to upswings or downswings in market prices. A “factor” implies a statistical modeling of variables and their impact on price movements. A risk factor could be anything that we believe meaningfully influences the change in fear or greed in the marketplace. Said differently, it’s about the study of the current market narrative and what may surprise markets. Examples are the potential onset of a recession, an emerging market country defaulting on its debt, or a large hedge fund or company collapsing. Finding similar events in the past and studying the subsequent market responses can be somewhat useful but drawing too heavily from historical precedent is usually dangerous because the market backdrop is always different. The nature of markets is such that small changes in backdrops can produce very different market reactions and render generalizations drawn from historical precedent exceedingly difficult to make. For example, the market reaction to an EM country going bust in ‘97 when globalization of financial markets was less mature can be drastically different than if something similar happened today.

Bubbles play a critical role in our risk factor analysis. The presence of a bubble represents a risk. Positive feedback loops are always in motion and can take prices far away from equilibrium (forming of a bubble) and when this reverses (popping of a bubble) it could ignite a chain reaction of selling across risk assets. Some bubbles are more pernicious than others through their size, linkage to the real economy, and leverage employed. For example, the housing bubble checked all three marks however the ‘99 internet bubble was far less linked to the real economy.  Many economists and market participants believe that bubbles cannot be detected ex ante. While we agree that in many cases a bubble might be hard to identify, in certain cases you can know with certainty a bubble is forming and that it will collapse. This belief draws heavily from Didiere Sornette’s1 work on unsustainable growth which he defines as price action that is hyperbolic (not to be confused with exponential) and must reach the point of failure in finite time. This is mathematically true. To be clear, this doesn’t mean we can predict bubbles but sometimes it is apparent that one is forming, and this knowledge is a useful input when it comes to the calibration of our risk-taking.


In this paper, we hope to present our framework for assessing risk-taking at the portfolio level. It is grounded in a belief system that attempts to come to terms with the fact that we are making investment decisions in a world that we do not fully understand. As researchers, we tirelessly use real-world data to make assumptions about the metaphysical characteristics of markets. No matter how much work we do or data we gather or how smart we think we are, there will always remain an irreducible level of uncertainty and this framework is our best response to this philosophical reality.

1Sornette, D. (2020). Bubbles for Fama from Sornette. Swiss Finance Institute

Past performance is not necessarily indicative of future results. All investments carry significant risk, and it’s important to note that we are not in the business of providing investment advice. All investment decisions of an individual remain the specific responsibility of that individual. There is no guarantee that our research, analysis, and forward-looking price targets will result in profits or that they will not result in a full loss or losses. All investors are advised to fully understand all risks associated with any kind of investing they choose to do.