Spending Active Risk

Suppose we have passed the first two tests. We understand an investment well enough to make a judgement, and we can explain why our knowledge, circumstances or position give us an edge. There is still a third question to answer:

How much of our capital should depend on us being right?

This is where an investment idea becomes portfolio construction.

Active risk is not limited to picking stocks. It is the part of our financial outcome that depends on our judgement, or that of someone we select, producing a better result than the readily available alternative. Choosing an active manager spends it. Owning more of one country than another spends it. Holding a concentrated position, selecting a private fund, keeping excess cash or making a direct investment all spend it.

For a one person family office, active risk consumes two scarce resources at once: capital and attention. Both need to be allocated deliberately.

How much should being wrong matter?

There is a useful idea in investment mathematics known as the Kelly criterion. The formula need not concern us here; its intuition should.

The more attractive an opportunity and the greater our confidence in the advantage, the more capital it can justify. But uncertainty about that advantage should push us in the opposite direction. And the costs of being too cautious and too aggressive are not symmetrical.

If we allocate 3 per cent to an opportunity that deserved 6 per cent, we have forgone some return. If we allocate 30 per cent to something that deserved 6 per cent, an ordinary mistake can materially change the family’s circumstances.

This becomes particularly important when potential returns are very high but the range of outcomes is wide. Imagine an early-stage company where we believe there is a plausible path to making ten times our money, but also a substantial chance of losing the entire investment. The upside may justify participating. It does not justify behaving as though our estimate of the probabilities is precise.

In real portfolios, it rarely is. Outcomes are connected, estimates of edge are uncertain, and family capital has purposes beyond maximising theoretical compound growth. The practical lesson from Kelly is therefore restraint, not mathematical bravado.

Position sizing is therefore not a way of displaying conviction. It is a way of deciding how much being wrong is allowed to matter.

Large enough to matter

There is an opposite problem.

Private portfolios are particularly prone to accumulating small investments. An idea sounds interesting, a manager is persuasive, a friend brings an opportunity or we want exposure to a theme. We invest enough to participate but not enough for success to make much difference to the overall portfolio.

The capital committed may be small. The attention required often is not.

A 0.5 per cent direct investment can still require reading reports, taking calls, following developments, making decisions and worrying when something goes wrong. Accumulate enough positions like this and a surprisingly large amount of attention is devoted to investments that can barely affect the family’s financial outcome.

Small positions are cheap in capital but expensive in attention.

That does not make every small position pointless. A research position can be useful precisely because real money changes the quality of attention. We read the results. We notice developments. We test our assumptions against reality.

But it should be labelled for what it is. If a position is deliberately too small to have much financial effect, we should know what we expect to learn from owning it, when we will reassess it and what would justify making it larger.

Otherwise the portfolio gradually fills with souvenirs of ideas we once found interesting.

Attention is part of position sizing

Position size therefore has another dimension for the one person family office.

A diversified set of broad market exposures may require little continuing attention. Five direct investments or ten external managers can create a very different operational burden. Each brings documents, decisions, tax consequences, capital calls, relationships and things that can go wrong.

At some point, adding another investment no longer improves the portfolio enough to justify the additional claim on the person running it.

There is a point at which more investments no longer create diversification. They create an organisation.

This is an unusual constraint, but also a useful one. A one person office does not need to replicate an institutional portfolio. It can leave large parts of the balance sheet doing relatively ordinary things and reserve its attention for the relatively few decisions where active judgement is likely to be valuable.

Correlations between decisions

Investment decisions naturally arrive one at a time. Portfolio risk does not.

A technology investment may look attractive on its own. So may a venture fund, a growth-oriented public-equity manager and a private company whose revenues depend on the same investment cycle. Each can survive its individual underwriting process while collectively creating a much larger exposure than anyone intended.

Traditional diversification looks for correlations between assets. A one person family office must also look for correlations between decisions: repeated beliefs about growth, liquidity, leverage, a country, a technology or the kind of person we trust.

This is particularly important because all the decisions are being made by the same person.

We may consistently prefer charismatic founders. We may repeatedly underestimate leverage. We may be attracted to businesses that require abundant capital or managers with similar investment styles. Those positions can appear unrelated in a spreadsheet while sharing the same judgement underneath.

In a one person family office, the most important correlation may sometimes be between the decisions rather than between the assets.

The defence is simple but easily neglected: every time something is added, return to the whole portfolio. Do not ask only what the new investment can lose. Ask what else is likely to be going wrong when it loses.

Illiquidity spends tomorrow’s flexibility

Private investments make this portfolio perspective especially important.

A ten-year commitment does more than expose capital to an investment. It reduces the set of decisions available later. Capital calls may arrive during weak markets. An attractive opportunity may appear when liquidity is scarce. Family circumstances may change.

This does not make illiquidity undesirable. It means its cost cannot be measured only by comparing expected returns.

For a one person family office, flexibility can itself be a source of edge. The ability to provide capital when someone else needs liquidity, to hold through a dislocation or simply to wait for a better opportunity has economic value.

An illiquid investment consumes some of that capacity.

Illiquidity therefore spends tomorrow’s flexibility as well as today’s capital.

That should be reflected in position size. An attractive private opportunity can deserve a smaller allocation than its expected return alone would suggest because the commitment removes choices we may value later.

The Active Risk Audit

Periodically, it is useful to stop reviewing investments individually and review the decisions embedded in the portfolio instead.

What outcomes does the family now depend upon? Which investments are likely to disappoint together? Where have we expressed the same judgement several times? Which positions consume attention without being large enough to contribute meaningfully? How much usable liquidity would remain in the circumstances in which we would most need it?

And one question is particularly revealing:

If the entire portfolio arrived in cash today, which positions would we rebuild?

The answer will rarely be “all of them.”

That does not mean everything else should immediately be sold. Tax, transaction costs, liquidity and other frictions are real. But the gap between the portfolio we would build today and the one we actually own tells us where history, inertia and accumulated decisions have begun to substitute for intention.

Spend judgement where it counts

Competence and edge get us only so far. Eventually an investment has to become a position, and that means deciding how much of the family’s outcome should depend on our judgement being right.

That decision cannot be made from the investment case alone. It depends on what else we own, what could go wrong at the same time, how much flexibility we are giving up and how much attention the position will require.

A one person family office does not need to express every view it holds. It can leave much of the portfolio doing relatively ordinary things, preserve attention and flexibility, and take meaningful risk in the few places where judgement is genuinely worth putting at stake.

The difference between a good investment and a good portfolio decision is usually size, context, or both.