Summary There are two risks associated with stock investing: idiosyncratic risk, and market risk. Checklists of fundamental analysis questions protect against neither. To limit your risk, you need a checklist with just two questions on it: “Am I diversified?” and “Am I hedged?” Diversification can protect you against idiosyncratic risk; hedging can protect you against both idiosyncratic risk and market risk. We show how to build a portfolio that protects against both risks and present a sample protected portfolio. The Checklist Manifesto Last December, as I sat hooked up to intravenous lines in the pre-op room of a surgical center, my orthopedist stopped to check in before I went under. I asked him if he remembered which shoulder he was supposed to operate on, and he took a magic marker and drew an arrow on my right shoulder, near the arrow a nurse had me mark there earlier, with my good arm. That point of that was to avoid an “error of ineptitude”, as surgeon and author Atul Gawande , MD, MPH, terms it. Avoiding errors of ineptitude, by using checklists, was the subject of Dr. Gawande’s 2009 bestseller, The Checklist Manifesto , pictured below. Checklist Investing The seed for Gawande’s book was his New Yorker article published at the end of 2007 (“The Checklist”). In a January, 2013 interview with Motley Fool (“Checklist Investing: How to Avoid Errors and Learn From Mistakes”), hedge fund manager Mohnish Pabrai discussed how that initial article influenced him, and caused him to reach out to Atul Gawande, who later included him in his book: I think after I got my head handed to me in 2008, the funds were down 60%; I think one of them was more than 60% in 2008, and the markets were down 38% or so, so we underperformed the markets by some margin in 2008. So I did a lot of soul searching on what I was missing, and I happened at the time to read a book by Atul Gawande; actually, I read an article first in The New Yorker , which was on the checklist, where he applied it to the medical field, and then subsequent to that, I had conversations with Atul, and he actually made it into a book called The Checklist Manifesto… Pabrai went on to note in that interview that he had developed a checklist with “97 or 98” fundamental analysis questions on it. Presumably, Pabrai went through those 97 or 98 questions before adding to his Horsehead Holdings (NASDAQ: ZINC ) stake in October of 2013. Here’s a look at how ZINC has traded since then. As of last quarter, Pabrai’s Dalal Street, LLC was the largest institutional holder of ZINC, with over 11% of its shares. Checklists Don’t Limit Risk Like the margin of safety concept, 98-question checklists may be helpful for security selection. They just don’t limit either of the two kinds of risk associated with stock investing: idiosyncratic risk , the risk of something bad happening to one of the companies you own, and market risk , the risk of your investments suffering due to a decline of the market as a whole. A Two Question Checklist Here is a simple, two question checklist to determine if you are protected against idiosyncratic, or stock-specific risk: Am I diversified? Am I hedged? If you’re diversified, than the impact to your portfolio of a decline in one stock is limited to the percentage of your portfolio allocated to that stock. So, for example, if you have 20 equal-weighted stocks, and one loses 50% of its value, all else equal, your portfolio would be down by 2.5% (since you had 5% allocate to each stock, and 0.5 x 5 = 2.5). If your idiosyncratic risk is covered by diversification, you can use a simple form of hedging to limit your market risk . According to the article linked to above, though, ZINC was one of only 6 stocks in Pabrai’s portfolio in 2013, so he was running a concentrated portfolio, rather than a diversified one. In a concentrated portfolio, since diversification isn’t limiting your idiosyncratic risk, you can use hedging to limit both idiosyncratic and market risk. The hedged portfolio method offers a way to do that while maximizing your expected return. Below we’ll run through the process of creating a hedged portfolio to limit both idiosyncratic and market risk, and provide an example. First, we need to note the tradeoff between risk tolerance and expected return. Risk Tolerance, Hedging Cost, And Expected Return All else equal, with a hedged portfolio, the greater an investor’s risk tolerance – the greater the maximum drawdown he is willing to risk (his “threshold”) – the higher his expected return will be. So, for example, an investor willing to risk a decline of 28% would likely have a higher expected return than one willing to risk a decline of only 8%. We’ll split the difference below, and construct a hedged portfolio for an investor who is willing to risk a decline of no more than 18%, and has $200,000 to invest. Constructing A Hedged Portfolio The process, in broad strokes, is this: Find securities with high potential returns (we define potential return as a high-end, bullish estimate of how the security will perform). Find securities that are relatively inexpensive to hedge. Buy a handful of securities that score well on the first two criteria; in other words, buy a handful of securities with high potential returns net of their hedging costs (or, ones with high net potential returns). Hedge them. The potential benefits of this approach are twofold: If you are successful at the first step (finding securities with high potential returns), and you hold a concentrated portfolio of them, your portfolios should generate decent returns over time. If you are hedged, and your return estimates are completely wrong, on occasion – or the market moves against you – your downside will be strictly limited. How To Implement This Approach Finding securities with high potential returns For this, you can use Seeking Alpha Pro , among other sources. Seeking Alpha articles often include price targets for long ideas, and you can convert these to percentage returns from current prices. But you’ll need to use the same time frame for each of your expected return calculations to facilitate comparisons of expected returns, hedging costs, and net expected returns. Our method starts with calculations of six-month potential returns. Finding Securities That Are Relatively Inexpensive To Hedge For this step, you’ll need to find hedges for the securities with high potential returns, and then calculate the hedging cost as a percentage of position value for each security. Whatever hedging method you use, for this example, you’d want to make sure that each security is hedged against a greater-than-18% decline over the time frame covered by your potential return calculations. Our method attempts to find optimal static hedges using collars as well as protective puts. Buying Securities That Score Well On The First Two Criteria To determine which securities these are, you may need to first adjust your potential return calculations by the time frame of your hedges. For example, although our method initially calculates six-month potential returns and aims to find hedges with six months to expiration, in some cases the closest hedge expiration may be five months out. In those cases, we will adjust our potential return calculation down accordingly, because we expect an investor will exit the position shortly before the hedge expires (in general, our method and calculations are based on the assumption that an investor will hold his shares for six months, until shortly before their hedges expire or until they are called away, whichever comes first). Next, you’ll need to subtract the hedging costs you calculated in the previous step from the potential returns you calculated for each position, and sort the securities by their potential returns net of hedging costs, or net potential returns. The securities that come to the top of that sort are the ones you’ll want to consider for your portfolio. Fine-Tuning Portfolio Construction You’ll want to stick with round lots (numbers of shares divisible by 100) to minimize hedging costs. Another fine-tuning step is to minimize cash that’s leftover after you make your initial allocation to round lots of securities and their respective hedges. Because each security is hedged, you won’t need a large cash position to reduce risk. And since returns on cash are so low now, by minimizing cash you can potentially boost returns. In this step, our method searches for what we call a “cash substitute”: that’s a security collared with a tight cap (1% or the current yield on a leading money market fund, whichever is higher) in an attempt to capture a better-than-cash return while keeping the investor’s downside limited according to his specifications. You could use a similar approach, or you could simply allocate leftover cash to one of the securities you selected in the previous step. Calculating An Expected Return While net potential returns are bullish estimates of how well securities will perform, net of their hedging costs, expected returns, in our terminology, are the more likely returns net of hedging costs. In a series of 25,412 backtests over an 11-year time period, we determined two things about our method of calculating potential returns: it generates alpha, and it overstates actual returns. The average actual return over the next six months in those 25,412 tests was 0.3x the average potential return calculated ahead of time. So, we use that empirically derived relationship to calculate our expected returns. An Automated Approach Here we’ll show an example of creating a hedged portfolio using the general process described above, facilitated by the automated hedged portfolio construction tool at Portfolio Armor . In the first field below, we’re given the choice of entering our own ticker symbols. Instead, we’ll leave that field blank, and let the site pick its own securities for us. In the second field, we enter the dollar amount of our investor’s portfolio (200000), and in the third field, the maximum decline he’s willing to risk in percentage terms (18). Next, we clicked the “create” button. A couple of minutes later, we were presented with the hedged portfolio below. The data here is as of Thursday’s close. Worst-Case Scenario The “Max Drawdown” column in the portfolio level summary shows the worst-case scenario for this hedged portfolio. If every underlying security in it went to zero before the hedges expired, the portfolio would decline 16.94%. Negative Hedging Cost Note that, in this case, the total hedging cost for the portfolio was negative, -0.12%, meaning the investor would receive more income in total from selling the call legs of the collars on his positions than he spent buying the puts. Best-Case Scenario At the portfolio level, the net potential return is 15.21%. This represents the best-case scenario, if each underlying security in the portfolio meets or exceeds its potential return. A More Likely Scenario The portfolio level expected return of 5.97% represents a more conservative estimate, based on the historical relationship between our calculated potential returns and actual returns. Each Security Is Hedged Note that in the portfolio above, each underlying security is hedged. BofI Holding (NASDAQ: BOFI ), JetBlue Airways (NASDAQ: JBLU ), Sketchers, USA (NYSE: SKX ), and Tyler Technologies (NYSE: TYL ) are hedged with optimal collars with their caps set at their respective potential returns. Amazon.com (NASDAQ: AMZN ) is hedged as a cash substitute, with an optimal collar with its cap set at 1%. Hedging each security according to the investor’s risk tolerance obviates the need for broad diversification, and lets him concentrate his assets in a handful of securities with high potential returns net of their hedging costs. Here’s a closer look at the hedge for one of these positions, JBLU: As you can see in first part of the image above, JBLU is hedged with an optimal collar with its cap set at 20.87%, which was the potential return Portfolio Armor calculated for the stock: the idea is to capture the potential return while offsetting the cost of hedging by selling other investors the right to buy JBLU if it appreciates beyond that over the next six months. The cost of the put leg of this collar was $1,950, or 4.93% of position value, but, as you can see in the image below, the income from the short call leg was $1,425, or 3.6% as percentage of position value. Since the income from the call leg offset some of the cost of the put leg, the net cost of the optimal collar on ISRG was $525, or 1.33% of position value.[i] Note that, although the cost of the hedge on this position was positive, the hedging cost of this portfolio as a whole was negative . Why These Particular Securities? Portfolio Armor doesn’t use a 98-question checklist to rank its universe of securities, which consists of every hedgeable security traded in the U.S. It looks at two factors to estimate potential returns: price history, and option market sentiment. Then it subtracts hedging costs to calculate potential returns net of hedging costs, or net potential returns. The securities included in this portfolio had some of the highest net potential returns in Portfolio Armor’s universe on Thursday. Possibly More Protection Than Promised In some cases, hedges such as the ones in the portfolio above can provide more protection than promised. For an example of that, see this recent instablog post on hedging Tesla (NASDAQ: TSLA ). Hedged Portfolios For More Risk-Averse Investors The hedged portfolio shown above was designed for an investor who could tolerate a decline of as much as 18% over the next six months, but the same process can be used for investors who are even more risk-averse, willing to risk drawdowns of as little as 2%. —————————————————————————– Notes: [i] To be conservative, the net cost of the collar was calculated using the bid price of the calls and the ask price of the puts. In practice, an investor can often sell the calls for a higher price (some price between the bid and ask) and he can often buy the puts for less than the ask price (again, at some price between the bid and ask). So, in practice, the cost of this collar would likely have been lower. The same is true of the other hedges in this portfolio, the costs of which were also calculated conservatively.