Before I start this morning, I would simply like to point out these five old articles of mine, because they will be relevant to my argument:
- The Rules, Part XXXVIII (There is probably money to be made in analyzing the foibles of money managers, to create new strategies by taking on the opposite of what they are doing.)
- The Portfolio Rules Work Together
- “Do Half”
- Risk Control Upfront & Risk Control Upfront, Redux
My contention is that most institutional investors are biased toward action, not inaction, and that is probably true of many “hands on” amateur investors as well. In many cases they would be better off doing nothing, doing less, or at worst, doing half. Quoting from that piece:
But the real benefit of doing half is the psychology of the situation. Many investors suffer from fear, greed, and regret. Doing half short-circuits those responses. When the stock price moves in favor of profits, be glad of those profits. When the stock price moves against profits, reanalyze and either a) go flat, recognizing your mistake, and being grateful that it was small, or b) increase the bet to a full position, and be grateful that you didn’t put a full position on initially.
But often an investor finds himself in a psychological “Zugzwang.” [That’s a chess term for compulsion to move.] One of your investments has been revealed to be a blunder, and now you deal with regret, or worse yet, a desire to catch up [envy, greed]. Let me suggest a solution. Just as there are no good macroeconomic policies after a financial crisis — one must seek to stop the next crisis, not fix the current one, the same thing applies to the intelligent investor, where we go back to first principles:
- Did I have an adequate margin of safety?
- Did I buy it cheap relative to prospects? Were my expectations too rosy relative to what could have been seen, given data known prior to the revelation of the error? Did anyone else get it right?
- Did I understand the industry prospects well enough, and how my company interacted there?
- Did the management team surprise me by misusing free cash flow, borrowing capacity, etc?
- Were there accounting problems that I should have seen?
- Did I size the position right?
- Did I reduce exposure and add exposure to the right companies via my normal portfolio management processes?
Now, these correspond to my portfolio rules, in a jumbled way. If you have analyzed risk well on a forward-looking basis, when a small problem hits, the stock should be off a few percent. When a big problem hits, maybe off 10%. Having a strong margin of safety protects the downside, and keep you from being a forced seller. Most investment ideas take time to work out. A company may do well for years, and then all of a sudden it gets discovered and takes off. On lesser-known companies, where internal value is growing, I don’t mind seeing a flat chart. Eventually value will be discovered.
With an adequate margin of safety, a disaster can be a time to add, if long-term prospects are not unduly damaged. The company with the disappointment must compete against the rest of your portfolio for capital, so after a disappointment, remeasure how you think it would rank as a new position in your portfolio. If you didn’t own it, would you buy it?
The idea here is to do risk control upfront. The reward to this is that you will make fewer decisions, and better decisions. You won’t have to sweat as many ugly scenarios, and so you can spend more time knowing your companies better, so that you have an information advantage versus most of your competitors. You will do less trading, but have better investment results. This is a case where more is less, and many of the leading value investors (Buffett, Klarman, etc.) would concur. I can see it now, “The Less is More Guide to Investing.”
It would certain help some institutional investors with their foibles. High portfolio turnover does not usually produce great returns (there are notable exceptions). Get out of the short-term performance business, and into the long-term, if you can. Trade less; analyze and invest more. Spend less time on day-to-day gyrations, and look for what is ignored by the market. Start playing a game that you might have a chance of winning, and develop your own edge. It’s a tough market, but you can make it tougher for everyone else by approaching it from a valid angle that few others do.
In the end you will make fewer decisions, but the decisions will be higher quality. Less will be more, and what’s more, your clients will like it, and not mind that your life just got a lot easier.
By David Merkel, CFA of Aleph Blog