Reverse Skewness: The Denominator Effect

by: Nadav Manham November 18, 2008    

Nadav Manham

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Back in April I posted on skewness and its importance to investment returns.

The denominator effect, as discussed in the Fortune article, is a little like skewness in reverse.  Rather than letting your winners ride and allowing them to comprise a larger portion of your portfolio, the denominator affect compels investors to sell their winners, at huge discounts, in the interests of portfolio rebalancing.

I'm sort of of two minds about this.  On the one hand I'm an advocate of skewness for professional investors.  The point of active investing is to pick winners, and you can't get the most out of your winners unless you let them ride, which means you must accept skewness as the outcome of your success.  What's the pointing of working so hard to identify winning PE funds, and then paying their managements so much, if you don't hold on long enough to reap the benefits?  On the other hand, it can be a good idea to shift assets from winners, or cash, to losers because the losers may now be undervalued, and because diversification may be an end in itself.

Whatever, I could ponder this all day, but there is a way to cut the gordian knot -- valuation, or its flip side, expected return.  I think it was either Peter Lynch or Julian Robertson who said something like "there is no such thing as a hold  --every day you wake up and start your portfolio from scratch, and if you hold on to a position you're really rebuying it." 

So if I'm an endowment with holdings in various asset classes -- hedge funds, private equity LP interests, stocks, real estate, etc .-- I would force myself to do two things:

1)  Forget what you own and ask yourself "if I started from scratch, how would I position the portfolio for maximum LT return?"

2)  Invert your thinking from price to expected return.  Don't say "I own assets priced at $A, $B, $C, etc."  Say instead "I own assets with an expected return of X%, Y%, Z%"

Then do your rebalancing, paying attention to your other needs (liquidity, diversification, etc.).

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This article has 2 comments:

  •  
    Nov 18 06:02 PM
    What are these "winners" you speak of?
    Reply | Link to Comment
  •  
    Nov 18 09:20 PM
    UUP, short term.
    Reply | Link to Comment
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