Portfolio thinking is what we call the process of evaluating a series of related positions and trades as a whole rather than individually. Portfolio thinking goes well with the idea of market neutrality because there are only two ways to be market neutral. The first is to be out of the market entirely. The second is to have a collection of positions (a portfolio) that offset each other's risk and reward profiles.

Portfolio thinking is not always natural. We talk to many people who want to win on every trade they make. While that would be nice, it is unrealistic. Thinking that way is even more problematic in a market-neutral context. Because market-neutral hedgers make trades to offset the risk and reward of other positions, it is highly unlikely every part of a portfolio will be profitable. Instead, traders with a portfolio mindset evaluate the portfolio's performance as a whole.

Thinking about things as a whole eliminates the pressure to be "right" about each trade or at least changes the definition of "right." When making a trade to manage a portfolio's risk, the standard for "right" is the trade that most efficiently restores the portfolio's desired balance. There is an immense psychological benefit from thinking this way.

When a portfolio's risk is beyond predetermined limits, a trade becomes necessary to restore the desired balance. All that's left for the portfolio manager to do is determine the best way to bring the portfolio back into alignment. Even if that trade is not profitable itself, it is still a decent trade if it accomplishes managing the portfolio's risk. Thinking about a portfolio and its goals, then creating a strategy to achieve those goals, shifts the overall thought process to the longer term. Long-term thinking is generally an excellent tool for survival.

By defining portfolio goals and risk limits ahead of time, hedgers can create a strategy that allows them to prepare for various market environments. Knowing what to expect when the unexpected happens, and having a plan to manage those situations, makes heat-of-the-moment decisions much more straightforward. Traders armed with the tools to understand and manage their risk and a plan for the unexpected are more likely to stay disciplined under challenging circumstances. Staying disciplined and avoiding emotional decisions is almost always better than not.

Of course, portfolio thinking is not a silver bullet. The most obvious drawback is that it will undoubtedly underperform being right all the time. That should not be too much of a concern. If you are right all the time, you probably are not reading this. A less obvious drawback is that the predetermined portfolio thinking strategies can limit creativity and create a "We've-always-done-it-this-way." mentality. Good plans have built-in places to pause and reassess. Our Quartzite Precision Marketing program for grain and soybean producers takes that break weekly during our scheduled call with each producer. Those calls allow us to check in on crop conditions and get feedback from our clients.

In the end, portfolio thinking is an excellent tactic for creating disciplined plans that limit emotional inputs into decision-making. Of course, any strategy's output will only be as good as the inputs, the model used, and how it performs in the market conditions it faces. That makes it imperative to have a well-designed program that can adapt to a variety of market conditions. At Quartzite, we have spent years learning that process and continuously strive to improve. If you are interested in learning more about our methods, contact us.