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John is the Outsourced Chief Investment Officer (OCIO) at Secfi. An expert in portfolio construction and investments, he helps individuals maximize returns and control risks unique to their situation.
Moneyball: The Art of Winning an Unfair Game, the book written by Michael Lewis and later made into a movie starring Brad Pitt, tells the story of how Major League Baseball manager Billy Beane used rigorous statistics to build a winning team on a limited budget. The Oakland A’s approach was so successful that it’s now standard across sports.
A similar revolution has been happening in parts of the investment world. Some of my former quantitative finance professors have even made a second career in sports analytics by applying similar techniques from investing research to athletics.
In investing, the “Moneyball” approach goes by many names: quantitative, systematic, factor, and smart beta, just to name a few. The essential idea is that certain stock characteristics can provide insights into future expected returns. Additionally, stocks with similar characteristics or “factors” tend to behave similarly to each other and differently from stocks with different characteristics.
Think of it this way—what are the characteristics, or factors, of a baseball team that boost their chances of winning? At the most basic level, it’s the ability to score runs and prevent runs from being scored against you. Hitting, pitching, defense, base running, coaching, etc. all play roles in the team’s success (or lack thereof).
In factor investing, researchers analyze data to find the stock characteristics that reliably impact a portfolio’s return and variability (i.e. the chances of winning). Many factors have been documented by researchers. Well-studied factors include relative value, quality, momentum, size, trend, volatility, and company profitability. Portfolio managers look to build portfolios informed by these factors for their clients in an attempt to outperform and/or manage risks better.
At Secfi Wealth, we build portfolios for our clients with exposure to factors we believe will outperform over the long run, while seeking to mitigate risks for our tech-employed and equity-compensated clients.
Going back to the baseball analogy, hitting home runs is generally a good thing in baseball. But sometimes players who hit lots of home runs strike out a lot too. They’re “swinging for the fences.” Jose Canseco was one player who swung for the fences. He hit 452 career home runs but also is among the top ten players for most strikeouts. If you were building a baseball team, would you want nine players like Jose Canseco on the field? Probably not! You might hit a lot of home runs, but your season would be extremely volatile and you’d probably lose more often than you win.
To extend the metaphor, employer stock options in your portfolio are like having Jose Canseco on your baseball team. A great player who can really knock it out of the park, but there’s a real risk that he strikes out completely as well. What should the rest of your team look like if you have Jose Canseco? Different from Jose! To increase the odds of a winning season, you need to round out the skills of your team to fill the missing gaps.
To increase the odds of investing success, we believe people with concentrated wealth in their company stock should emphasize complementary factors in the rest of their portfolio. The market environment in which it’s easier to hit a home run with your concentrated stock is an environment where other stocks with similar characteristics (factor exposure) are probably doing well.
If the rest of your portfolio favors these types of companies, you may be loading up on metaphorical Jose Cansecos, which will be awesome if they hit a bunch of home runs, but devastating if they strike out.
In an environment where it’s more difficult for your private company to exit successfully (i.e. strike out), it’s also likely that public companies with similar characteristics are suffering too. For example, 2022 was a terrible year for public tech stocks, and an awful year for VC-backed startups.
Rather than loading up on the same factors, we believe it’s better to build a portfolio that’s complementary to the home run hitting potential you have with your private stock. The highs may not be as high, but the lows won’t be as low either—and on average, we believe you’ll come out ahead.
At Secfi Wealth, we often see initial portfolios that are heavy on stocks that share a similar profile to the potential client’s employer. That’s understandable—people like to invest in what they know—but we believe there’s a better way to put the odds in your favor. And with the prospect of retirement becoming seemingly more and more challenging these days, we can all use every edge we can get.