Portfolio Management: Look Forward, Avoid Regret

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Portfolio Management: Look Forward, Avoid Regret
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In institutional portfolio management, the two hardest things to do are to buy higher than your last buy, and sell lower than your last sale.

Portfolio Management: Look Forward, Avoid Regret

I’ll tell you about two former bosses that I had. They are both good men, and I respect them both.  The first one taught me about bond management.  He had a difficulty though.  Typically, he did not like to trade.  When I stepped into his role, but with far less experience, I traded a lot more than he did.  Because I traded more, and liquidity in the bond market is sporadic, I came up with the rule listed above.

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The boss had an interesting insight, though: he suggested when you get to large sizes, stocks and bonds are equally illiquid.  I tend to agree.  In my days, I have traded stocks and bonds where I was a disproportionate holder of them, more so with bonds than with stocks.  If you want to learn the microstructure of markets, there is no better training ground than with illiquid securities.  And if you hold a lot of any security, the position is illiquid.

Once you are big, it is hard to trade in and out of positions rapidly.  You have to scale in and scale out, and do it in such a way that you don’t tip your hand to the market, which would then move against you.  Now, it would be easy if you had a fixed estimate of value for the securities, so that you knew whether a proposed buy or sell made sense, but corporate bonds and stocks improve and deteriorate.

Imagine for a moment that you hold five percent of a company’s bonds, and to your surprise, the situation is deteriorating.  Bid prices are falling.  What do you do?  First question: are the bonds money good?  Will they pay off, with high likelihood?  If so, bide your time, and maybe add some more if you have room.  If not, the second question: so what are the bonds worth?  If less than the current price, start selling, but avoid the appearance that you are desperate.  You have a lot of bonds to sell.  For the market to absorb them all will be a challenge.  I would say to brokers, that I was willing to sell small amounts of bonds at the current market, but if someone wanted to buy my full position, I might be willing to compromise a little.  Then you can have negotiations.

More often, in a deteriorating situation, you sell in dribs and drabs as the price of the asset falls.  There is psychological pain as you sell lower, but a good manager dismisses it, forgetting the past and focusing on the future.

Then there was the other boss.  At the interview he asked me, “What is one of the hardest lessons you have learned?”  I said, “In institutional portfolio management, the two hardest things to do are to buy higher than your last buy, and sell lower than your last sale.”

He appreciated the answer, though he had a hard time applying it personally.  He had a tendency to look to the past more than me.  Over the years I have learned to be forward-looking and try to analyze what securities will do the best, regardless of my cost basis.

I got the largest allocation of the Prudential “C” bonds when the deal was done. but I bought an equal amount 10% higher in price terms when it was a great deal in relative terms.  It was tough to buy more at a higher price, but it was still a great yield on a misunderstood bond.

Regret is native to mankind, but you can’t change the past.  You can try to estimate the future.  Don’t think about your cost bases.  Rather, think about what an asset is truly worth, and its trajectory, and manage your buys and sells relative to that.

Forward-looking management wins.  Look forward, and avoid regret.

PS — On Scottish Re (spit, spit) we went through this process.  We bought and bought more as it went down.  I erred in my judgment.  Had I looked at the taxable income, I would have realized that a lot of the profits weren’t real.

Before the company announced its reorganization plan, we doubled our position at a very low price, but then sold the whole thing into an astounding rally when the company announced its plans.  That cut our losses considerably, and we didn’t buy it back.  Eventually, it was worth nothing.  Focus on the future; ignore the past.

Via: alephblog.com

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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