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AChecklistToSaveYourAssets
Sep.25,20151:32PMET9comments
by:DavidPinsen
Disclosure:I/wehavenopositionsinanystocksmentioned,andnoplanstoinitiateanypositionswithinthenext72hours.

Summary
Therearetworisksassociatedwithstockinvesting:idiosyncraticrisk,andmarketrisk.Checklistsoffundamental
analysisquestionsprotectagainstneither.
Tolimityourrisk,youneedachecklistwithjusttwoquestionsonit:"AmIdiversified?"and"AmIhedged?".
Diversificationcanprotectyouagainstidiosyncraticriskhedgingcanprotectyouagainstbothidiosyncraticriskand
marketrisk.
Weshowhowtobuildaportfoliothatprotectsagainstbothrisksandpresentasampleprotectedportfolio.
TheChecklistManifesto
LastDecember,asIsathookeduptointravenouslinesinthepreoproomofasurgicalcenter,myorthopediststoppedto
checkinbeforeIwentunder.Iaskedhimifherememberedwhichshoulderhewassupposedtooperateon,andhetooka
magicmarkeranddrewanarrowonmyrightshoulder,nearthearrowanursehadmemarkthereearlier,withmygood
arm.Thatpointofthatwastoavoidan"errorofineptitude",assurgeonandauthorAtulGawande,MD,MPH,termsit.
Avoidingerrorsofineptitude,byusingchecklists,wasthesubjectofDr.Gawande's2009bestseller,TheChecklist
Manifesto,picturedbelow.

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ChecklistInvesting
TheseedforGawande'sbookwashisNewYorkerarticlepublishedattheendof2007("TheChecklist").InaJanuary,
2013interviewwithMotleyFool("ChecklistInvesting:HowtoAvoidErrorsandLearnFromMistakes"),hedgefund
managerMohnishPabraidiscussedhowthatinitialarticleinfluencedhim,andcausedhimtoreachouttoAtulGawande,
wholaterincludedhiminhisbook:

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IthinkafterIgotmyheadhandedtomein2008,thefundsweredown60%Ithinkone
ofthemwasmorethan60%in2008,andthemarketsweredown38%orso,sowe
underperformedthemarketsbysomemarginin2008.[...]
SoIdidalotofsoulsearchingonwhatIwasmissing,andIhappenedatthetimeto
readabookbyAtulGawandeactually,IreadanarticlefirstinTheNewYorker,which
wasonthechecklist,whereheappliedittothemedicalfield,andthensubsequentto
that,IhadconversationswithAtul,andheactuallymadeitintoabookcalledThe
ChecklistManifesto...
Pabraiwentontonoteinthatinterviewthathehaddevelopedachecklistwith"97or98"fundamentalanalysisquestions
onit.Presumably,Pabraiwentthroughthose97or98questionsbeforeaddingtohisHorseheadHoldings
(NASDAQ:ZINC)stakeinOctoberof2013.Here'salookathowZINChastradedsincethen.

Asoflastquarter,Pabrai'sDalalStreet,LLCwasthelargestinstitutionalholderofZINC,withover11%ofitsshares.
ChecklistsDon'tLimitRisk
Likethemarginofsafetyconcept,98questionchecklistsmaybehelpfulforsecurityselection.Theyjustdon'tlimiteitherof
thetwokindsofriskassociatedwithstockinvesting:idiosyncraticrisk,theriskofsomethingbadhappeningtooneofthe
companiesyouown,andmarketrisk,theriskofyourinvestmentssufferingduetoadeclineofthemarketasawhole.
ATwoQuestionChecklist
Hereisasimple,twoquestionchecklisttodetermineifyouareprotectedagainstidiosyncratic,orstockspecificrisk:
1. AmIdiversified?
2. AmIhedged?
Ifyou'rediversified,thantheimpacttoyourportfolioofadeclineinonestockislimitedtothepercentageofyourportfolio
allocatedtothatstock.So,forexample,ifyouhave20equalweightedstocks,andoneloses50%ofitsvalue,allelse
equal,yourportfoliowouldbedownby2.5%(sinceyouhad5%allocatetoeachstock,and0.5x5=2.5).Ifyour

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idiosyncraticriskiscoveredbydiversification,youcanuseasimpleformofhedgingtolimityourmarketrisk.Accordingto
thearticlelinkedtoabove,though,ZINCwasoneofonly6stocksinPabrai'sportfolioin2013,sohewasrunninga
concentratedportfolio,ratherthanadiversifiedone.
Inaconcentratedportfolio,sincediversificationisn'tlimitingyouridiosyncraticrisk,youcanusehedgingtolimitboth
idiosyncraticandmarketrisk.Thehedgedportfoliomethodoffersawaytodothatwhilemaximizingyourexpectedreturn.
Belowwe'llrunthroughtheprocessofcreatingahedgedportfoliotolimitbothidiosyncraticandmarketrisk,andprovide
anexample.First,weneedtonotethetradeoffbetweenrisktoleranceandexpectedreturn.
RiskTolerance,HedgingCost,AndExpectedReturn
Allelseequal,withahedgedportfolio,thegreateraninvestor'srisktolerancethegreaterthemaximumdrawdownheis
willingtorisk(his"threshold")thehigherhisexpectedreturnwillbe.So,forexample,aninvestorwillingtoriskadecline
of28%wouldlikelyhaveahigherexpectedreturnthanonewillingtoriskadeclineofonly8%.We'llsplitthedifference
below,andconstructahedgedportfolioforaninvestorwhoiswillingtoriskadeclineofnomorethan18%,andhas
$200,000toinvest.
ConstructingAHedgedPortfolio
Theprocess,inbroadstrokes,isthis:
Findsecuritieswithhighpotentialreturns(wedefinepotentialreturnasahighend,bullishestimateofhowthesecurity
willperform).
Findsecuritiesthatarerelativelyinexpensivetohedge.
Buyahandfulofsecuritiesthatscorewellonthefirsttwocriteriainotherwords,buyahandfulofsecuritieswithhigh
potentialreturnsnetoftheirhedgingcosts(or,oneswithhighnetpotentialreturns).
Hedgethem.
Thepotentialbenefitsofthisapproacharetwofold:
Ifyouaresuccessfulatthefirststep(findingsecuritieswithhighpotentialreturns),andyouholdaconcentrated
portfolioofthem,yourportfoliosshouldgeneratedecentreturnsovertime.
Ifyouarehedged,andyourreturnestimatesarecompletelywrong,onoccasionorthemarketmovesagainstyou
yourdownsidewillbestrictlylimited.
HowToImplementThisApproach
Findingsecuritieswithhighpotentialreturns
Forthis,youcanuseSeekingAlphaPro,amongothersources.SeekingAlphaarticlesoftenincludepricetargetsforlong
ideas,andyoucanconvertthesetopercentagereturnsfromcurrentprices.Butyou'llneedtousethesametimeframefor
eachofyourexpectedreturncalculationstofacilitatecomparisonsofexpectedreturns,hedgingcosts,andnetexpected
returns.Ourmethodstartswithcalculationsofsixmonthpotentialreturns.
FindingSecuritiesThatAreRelativelyInexpensiveToHedge
Forthisstep,you'llneedtofindhedgesforthesecuritieswithhighpotentialreturns,andthencalculatethehedgingcostas
apercentageofpositionvalueforeachsecurity.Whateverhedgingmethodyouuse,forthisexample,you'dwanttomake
surethateachsecurityishedgedagainstagreaterthan18%declineoverthetimeframecoveredbyyourpotentialreturn
calculations.Ourmethodattemptstofindoptimalstatichedgesusingcollarsaswellasprotectiveputs.
BuyingSecuritiesThatScoreWellOnTheFirstTwoCriteria
Todeterminewhichsecuritiestheseare,youmayneedtofirstadjustyourpotentialreturncalculationsbythetimeframeof
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yourhedges.Forexample,althoughourmethodinitiallycalculatessixmonthpotentialreturnsandaimstofindhedges
withsixmonthstoexpiration,insomecasestheclosesthedgeexpirationmaybefivemonthsout.Inthosecases,wewill
adjustourpotentialreturncalculationdownaccordingly,becauseweexpectaninvestorwillexitthepositionshortlybefore
thehedgeexpires(ingeneral,ourmethodandcalculationsarebasedontheassumptionthataninvestorwillholdhis
sharesforsixmonths,untilshortlybeforetheirhedgesexpireoruntiltheyarecalledaway,whichevercomesfirst).Next,
you'llneedtosubtractthehedgingcostsyoucalculatedinthepreviousstepfromthepotentialreturnsyoucalculatedfor
eachposition,andsortthesecuritiesbytheirpotentialreturnsnetofhedgingcosts,ornetpotentialreturns.Thesecurities
thatcometothetopofthatsortaretheonesyou'llwanttoconsiderforyourportfolio.
FineTuningPortfolioConstruction
You'llwanttostickwithroundlots(numbersofsharesdivisibleby100)tominimizehedgingcosts.Anotherfinetuningstep
istominimizecashthat'sleftoverafteryoumakeyourinitialallocationtoroundlotsofsecuritiesandtheirrespective
hedges.Becauseeachsecurityishedged,youwon'tneedalargecashpositiontoreducerisk.Andsincereturnsoncash
aresolownow,byminimizingcashyoucanpotentiallyboostreturns.Inthisstep,ourmethodsearchesforwhatwecalla
"cashsubstitute":that'sasecuritycollaredwithatightcap(1%orthecurrentyieldonaleadingmoneymarketfund,
whicheverishigher)inanattempttocaptureabetterthancashreturnwhilekeepingtheinvestor'sdownsidelimited
accordingtohisspecifications.Youcoulduseasimilarapproach,oryoucouldsimplyallocateleftovercashtooneofthe
securitiesyouselectedinthepreviousstep.
CalculatingAnExpectedReturn
Whilenetpotentialreturnsarebullishestimatesofhowwellsecuritieswillperform,netoftheirhedgingcosts,expected
returns,inourterminology,arethemorelikelyreturnsnetofhedgingcosts.Inaseriesof25,412backtestsoveran11year
timeperiod,wedeterminedtwothingsaboutourmethodofcalculatingpotentialreturns:itgeneratesalpha,andit
overstatesactualreturns.Theaverageactualreturnoverthenextsixmonthsinthose25,412testswas0.3xtheaverage
potentialreturncalculatedaheadoftime.So,weusethatempiricallyderivedrelationshiptocalculateourexpectedreturns.
AnAutomatedApproach
Herewe'llshowanexampleofcreatingahedgedportfoliousingthegeneralprocessdescribedabove,facilitatedbythe
automatedhedgedportfolioconstructiontoolatPortfolioArmor.Inthefirstfieldbelow,we'regiventhechoiceofentering
ourowntickersymbols.Instead,we'llleavethatfieldblank,andletthesitepickitsownsecuritiesforus.Inthesecondfield,
weenterthedollaramountofourinvestor'sportfolio(200000),andinthethirdfield,themaximumdeclinehe'swillingto
riskinpercentageterms(18).

Next,weclickedthe"create"button.Acoupleofminuteslater,wewerepresentedwiththehedgedportfoliobelow.The
datahereisasofThursday'sclose.

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WorstCaseScenario
The"MaxDrawdown"columnintheportfoliolevelsummaryshowstheworstcasescenarioforthishedgedportfolio.If
everyunderlyingsecurityinitwenttozerobeforethehedgesexpired,theportfoliowoulddecline16.94%.
NegativeHedgingCost
Notethat,inthiscase,thetotalhedgingcostfortheportfoliowasnegative,0.12%,meaningtheinvestorwouldreceive
moreincomeintotalfromsellingthecalllegsofthecollarsonhispositionsthanhespentbuyingtheputs.
BestCaseScenario
Attheportfoliolevel,thenetpotentialreturnis15.21%.Thisrepresentsthebestcasescenario,ifeachunderlyingsecurity
intheportfoliomeetsorexceedsitspotentialreturn.
AMoreLikelyScenario
Theportfoliolevelexpectedreturnof5.97%representsamoreconservativeestimate,basedonthehistoricalrelationship
betweenourcalculatedpotentialreturnsandactualreturns.
EachSecurityIsHedged

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Notethatintheportfolioabove,eachunderlyingsecurityishedged.BofIHolding(NASDAQ:BOFI),JetBlueAirways
(NASDAQ:JBLU),Sketchers,USA(NYSE:SKX),andTylerTechnologies(NYSE:TYL)arehedgedwithoptimalcollarswith
theircapssetattheirrespectivepotentialreturns.Amazon.com(NASDAQ:AMZN)ishedgedasacashsubstitute,withan
optimalcollarwithitscapsetat1%.Hedgingeachsecurityaccordingtotheinvestor'srisktoleranceobviatestheneedfor
broaddiversification,andletshimconcentratehisassetsinahandfulofsecuritieswithhighpotentialreturnsnetoftheir
hedgingcosts.Here'sacloserlookatthehedgeforoneofthesepositions,JBLU:

Asyoucanseeinfirstpartoftheimageabove,JBLUishedgedwithanoptimalcollarwithitscapsetat20.87%,whichwas
thepotentialreturnPortfolioArmorcalculatedforthestock:theideaistocapturethepotentialreturnwhileoffsettingthe
costofhedgingbysellingotherinvestorstherighttobuyJBLUifitappreciatesbeyondthatoverthenextsixmonths.The
costoftheputlegofthiscollarwas$1,950,or4.93%ofpositionvalue,but,asyoucanseeintheimagebelow,theincome
fromtheshortcalllegwas$1,425,or3.6%aspercentageofpositionvalue.

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Sincetheincomefromthecalllegoffsetsomeofthecostoftheputleg,thenetcostoftheoptimalcollaronJBLUwas
$525,or1.33%ofpositionvalue.[i]Notethat,althoughthecostofthehedgeonthispositionwaspositive,thehedgingcost
ofthisportfolioasawholewasnegative.
WhyTheseParticularSecurities?
PortfolioArmordoesn'tusea98questionchecklisttorankitsuniverseofsecurities,whichconsistsofeveryhedgeable
securitytradedintheU.S.Itlooksattwofactorstoestimatepotentialreturns:pricehistory,andoptionmarketsentiment.
Thenitsubtractshedgingcoststocalculatepotentialreturnsnetofhedgingcosts,ornetpotentialreturns.Thesecurities
includedinthisportfoliohadsomeofthehighestnetpotentialreturnsinPortfolioArmor'suniverseonThursday.
PossiblyMoreProtectionThanPromised
Insomecases,hedgessuchastheonesintheportfolioabovecanprovidemoreprotectionthanpromised.Foran
exampleofthat,seethisrecentinstablogpostonhedgingTesla(NASDAQ:TSLA).
HedgedPortfoliosForMoreRiskAverseInvestors
Thehedgedportfolioshownabovewasdesignedforaninvestorwhocouldtolerateadeclineofasmuchas18%overthe
nextsixmonths,butthesameprocesscanbeusedforinvestorswhoareevenmoreriskaverse,willingtoriskdrawdowns
ofaslittleas2%.

Notes:
[i]Tobeconservative,thenetcostofthecollarwascalculatedusingthebidpriceofthecallsandtheaskpriceoftheputs.
Inpractice,aninvestorcanoftensellthecallsforahigherprice(somepricebetweenthebidandask)andhecanoften
buytheputsforlessthantheaskprice(again,atsomepricebetweenthebidandask).So,inpractice,thecostofthiscollar
wouldlikelyhavebeenlower.Thesameistrueoftheotherhedgesinthisportfolio,thecostsofwhichwerealsocalculated
conservatively.

Comments(9)
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MoonKilWoong,Contributor
YoumaybeinterestedinshiftingmoneytobondsconsideringtheimplicationsifYellenactuallydecides
toimplementnegativeinterestratesandpunishpeopleandcompaniesforholdingcash.Sucha
strategywillcausemorefrightinitsimplementationthanbenefit.
25Sep2015,01:55PM

tyc1386
I'mkindofdisappointedthatCASHisnotconsiderasaformofhedge.Yes,CASHisnotthesexistform
ofsecurity(closedto0%upsideandotherlimitations).However,becauseofthesamefact,CASHhas
0%downside.Whenthebearmarketsuddenlyappear,allsecuritieswouldgenerateacorrelationclose
to1withtheexceptionofCASH.
25Sep2015,02:56PM

DavidPinsen,Contributor
Authorsreply Holdingcashiscertainlyawaytoreduceyourrisk,andyou'rerightthat
correlationsofsecuritiesheadtowardoneduringasteepmarketselloff.But,unlikecash,put
optionhedgesonstocksandstockindexETFsareanticorrelatedtothemarket.Thatmeans
thatwhenthemarkettanks,theywillgoupinvalue,whereasyourcashpositionwon't.Andnot
onlywilltheputoptionsgoupinvalue,buttheywilldosoinanonlinearfashionweshowed
anexampleofthatinarecentarticle(http://seekingalpha.co...),whereanSPYputoption
spikednearly80%onadaythatSPYdropped4%.Becauseofthatnonlinearity,asmall
amountofmoneyallocatedtooptionscanprotectamuchlargerunderlyingpositionor
portfolio.Sowhenthemarketgoesup,optionscanbelessofadragonyourportfolio's
performancethanalargecashpositionwouldbe.
25Sep2015,05:58PM

Hardog
David
ExcellentarticleandexplanationofusingPArmorasavehicletohedge.Thistypeofhedgeappealsto
measitiseasytounderstand.Manytks.
27Sep2015,11:37PM

DavidPinsen,Contributor
Authorsreply Thanks,Hardog.Gladyoufoundithelpful.
28Sep2015,12:05AM

DavidPinsen,Contributor
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DavidPinsen,Contributor
Authorsreply ZINCisat78centsnow.Somuchforchecklists.
13Jan2016,11:32AM

HewittHeiserman,Contributor
David
Theproblemisnotthechecklistperse.It'sthecontentofthechecklist.
InZINC'scase,havingaquestionthatsays,"Exitwhenpricefallsbelow200daymoving
average"wouldhavegottenalongoutinthemidteens.
Fulldisclosure:Iamwritingachecklistbook.
hewitt
14Jan2016,09:48AM

DavidPinsen,Contributor
Authorsreply Youraiseaninterestingpoint,thathischecklistwaslikelylimitedto
fundamentalanalysis.
14Jan2016,02:12PM

BruceBohannon
IhaveAtul'sbook.Unfortunately,IshouldimplementitandothersimilarchecklistsMOREinthenear
future.ThanksDavidforthearticleandrefresher.
14Jan2016,09:41AM

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