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January 30, 2011

Three Types Of Positions

In my world, there are three types of positions—investments, speculations and trades. Before you buy a share, you need to mentally assign each position a category; otherwise you will regret it later on. Once you have your categories, it is bad form to change them. Risk control is critical and you have to make sure you adjust your positions correctly over time.

Let’s start with the most obvious category—investments. I invest in companies that I believe in—often looking for secular tailwinds to further power growth. These are businesses with strong competitive advantages, good management and high returns on capital. I intend to own these businesses for years.

Since I know these businesses well, I do not get scared by bad news or price volatility. At lower prices, I will usually buy more shares. I rarely sell them as they go higher. I’m not looking to make thirty percent or something—I’m looking to make five-fold or more. I don’t want to cut my gains short. I put these positions away and try to ignore the prices each day. I only sell when the shares have become ridiculously overvalued, or something has changed with the business or secular trend that I have been watching. I consider BDSec,Energold and my core gold position to be investments. Unless something changes, I intend to hold these.

Speculations are entirely different. These are educated guesses. Unlike an investment, it is harder to know if you are right or wrong. Often, it is a binary sort of situation or one with some elements of risk. For this reason, you have to size the position differently. I am fine with owning a whole lot of gold. I don’t want to own as much of a speculation. There is a not remote chance that I will be wrong. As a speculation goes in my favor, I want to sell a few shares. If it doubles, I sell some more. By the time it has tripled, I want to take a lot of my initial capital out and play with the “house’s money.” This isn’t because the business is bad or because I don’t like management, it is simply because there is more risk involved. Over time, if you are diligent about protecting your downside, you will make money on your winning speculations, but you will have losers as well

On a different note, if the shares decline in value, I am less likely to add to the position. It isn’t because I don’t like it—rather it is because I want to limit how much capital I can lose in any speculative name. I would consider AndeanApex Minerals, Fibrek and Mercer to be speculations. I’m probably right about at least two of these four—I just don’t know which ones. Fortunately, I don’t think I will lose too badly on any of them if wrong.

Finally, there are trades. These are positions where you think you have some sort of quantifiable advantage over a period of time. Risk control is absolutely critical. I put these on when I think my downside is limited and there is a near term catalyst. Once I have a gain, I immediately set a stop loss. I simply refuse to lose more than a few percent on one of these positions. More importantly, I size them even smaller than investments or speculations. Thus far, Man Financial and US Global Investors are the only trading positions I have talked about. These are short term and I do not take many of them. I only do them when I see a clear catalyst and a lot of upside if right.

The danger is that you have a trade that starts working—all of a sudden you think you’re smart and you turn it into an investment. That’s trouble because now you don’t know what to do when it goes against you or how to manage it as it goes higher. I like to be very disciplined about these sorts of things. You need a game-plan before you put the position on otherwise you are bound to let emotions get in the way of intelligent decisions. This may all seem very basic–it is. However, I am surprised how many people get caught off-guard when something goes wrong.

I have a hunch that volatility is going to begin increasing after some months with abnormally low volatility. You need to be prepared and you need to know how you want to adjust your exposure beforehand. Investment, speculation or trade? What is it? Make sure you know now.

Categories: Investment Strategy
Positions Mentioned: none

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