Saturday, 8 August 2015

Portfolio Construction Part 3 – Rule Your Portfolio

In my first two posts (Part 1 - Diversification, Diworsification?, Part 2 - The Matrix Revolution) I looked at how to determine the correct diversification level for your portfolio and a way to simply but optimally weight those assets. In the last part of this trilogy I will look at some simple rules that can help avoid behavioural biases creeping into our portfolios.

When you get to see the portfolios of most private investors they usually look something like this (based on a real world example from the web):

ABC 19.45%
BCD 12.37%
CDE 9.35%
DEF 6.58%
EFG 6.29%
FGH 5.97%
GHI 3.22%
HIJ 3.01%
IJK 2.90%
JKL 2.83%
KLM 2.74%
LMN 2.47%
NOP 2.45%
OPQ 2.20%
PQR 2.17%
QRS 2.12%
RST 1.95%
STU 1.89%
TUV 1.81%
UVW 1.49%
VWX 1.41%
XWY 1.14%
WYZ 1.12%
YZA 0.86%
ZAB 0.73%
CBA 0.64%
DCB 0.45%
EDC 0.39%

At 28 positions the diversification level is probably about right for an active stock-picker, however note the one or two large positions combined with a tail of very small positions

The Large Positions

Usually the large positions are the investor’s past big winners. I looked at asset weighting in part two and one of the key takeaways was that the largest positions should only be the investment ideas you believe to have the best return potential and the lowest risk. It is always worth re-evaluating your biggest positions to check that they really do match these criteria. Asking yourself the question ‘if I was forced to sell today would I seek to buy back in the same size as soon as possible?’ often helps understand if you have your position-sizing correct. Given the impact on your performance those largest positions will have it is worth setting aside a regular time to do this.

Employer Positions

The other common reason for people having a large holding as a percentage of portfolio is that they are the shares of their employer received through a share-save scheme or similar. I mentioned this briefly in part one. Sharesave or option schemes that allow one to own shares in one’s employer at a discount or without risk at the time of purchase can be a great deal. If you are a director of the company and can assess and influence the competitive strategy of the business it makes sense (and is often expected) to hold onto a significant proportion of these shares. However when you don’t have board level influence the shares should be treated just like any other investment. This means, for example, following the principles of portfolio weighting I discussed in part two. One of the risks I mentioned in that piece was correlation risk, the common exposure stocks have to factors that are out of your control. When it comes to your employer this risk is almost always large not because of the correlation with other stocks but the correlation with your salary. When your employer is performing and growing strongly you are more likely to get pay rises, bonuses or be promoted. Conversely when the business is struggling you are more likely to be made redundant. Your economic exposure to your employer is large whether you own shares or not. It pays to include this factor in your portfolio decision making process.

The Small Positions

The small positions usually have only one characteristic - they are the past losers. Once a shareholding is below a certain size it has very little influence on the future returns of your portfolio. A 0.5% holding would have to double to have the same influence as the normal daily noise movements of a 10% holding. So why do we end up with these holdings? I believe this is primarily loss aversion. We prefer the hope of a future gain no matter how unlikely or inconsequential to taking a definite loss today. One of my favourite examples of the loss aversion comes from the book ‘Beyond Fear & Greed’ by Hersh Schefrin summarised below:

Loss Aversion in a Real Estate Deal

Bill & his wife are in their early thirties and have just had their first child. A good friend, Jim, has been successful at investing in real estate deals for a few years suggests that they join him in his next deal. They put in all their $27.5k savings and borrow $75k to fund their half of a parcel of land which will be split into lots for housing and sold off, hopefully for a good return. Given the interest on the loan this investment is cash flow negative for Bill & his wife.

Some time passes and the land sales are not progressing as rapidly as Jim had hoped so he decides to put up a model home on the land. A year later the model home has been built and sold but has not generated more interest in the rest of the land. At this point James, feeling bad that he had got his friends into this, offers to take on their share of the deal. This would mean that Bill & his wife would lose their $27k but avoid any further losses from the loan financed on the land. Despite little experience of real estate investment and the real prospect of further cash outflows on the deal, being loss averse they declined the offer. Over the next few years James offered to buy them out but in each case they preferred the hope of a future gain to taking a definite loss today.

Now in the mean-time Bill became an elected official. At this point his future earning potential is so high that he shouldn’t rally care about $27.5k loss but being loss averse he does and allocates one of his aides to manage the real estate deal. Tragically that aide commits suicide and this leads to scrutiny of exactly what he was doing for Bill. At this point Bill is given a choice. He can accept a censure from Congress, essentially a slap on the wrist, or can agree to a wide ranging investigation into all his affairs. However the censure from Congress is a definite loss today. So being loss averse he prefers to risk the investigation. Unfortunately for him the wide-ranging investigation reveals that Bill is having a sexual relationship with an intern. Now at this point he can be honest, go on TV and beg forgiveness from his wife and constituents. However this would be a definite loss, so being loss averse he rolls the dice and prefers to gamble that they don’t have any evidence to back up the claim. So he goes on TV and says ‘ I did not have sexual relations with that woman.’ Of course we now know that President Clinton did have an affair with Monica Lewinsky, they did find evidence, and Bill was almost impeached as President of the United States. All because of loss aversion.

So the moral of the story is that if a man as successful & charismatic as Bill Clinton suffers from loss aversion so do you and me.

For this reason I have a rule. If a position drops below 1% of my portfolio and I’m not willing to add to the position to make it above 1% then I sell the whole position. If I don’t have the confidence to hold at least 1% this clearly isn’t my best investment idea. The small position size means that its potential impact is very low anyway so if it is still in my portfolio it is a sign that I am suffering from loss aversion. If I don’t clear out that long tail of losers they will take up emotional and mental energy that is best spent on my best ideas. Given the emotions that surround selling losers the 1% rule is surprisingly hard to implement but really worth doing.

The only case that I can see it being worth holding a very small number of shares is when you want to incentivise yourself to better understand a company. For some reason most investors are better at really kicking the tyres when they have some money on the line. This should not be an indefinite position though. You should set yourself a deadline at which point you assess the company and either add to the position or sell it. The downside to this strategy though is that ownership bias will probably make you rate the company more highly than you otherwise would. For this reason this should be used sparingly.


The other most common bias that impacts portfolios is ‘get-even-itis’. You probably have suffered from a case of this too. It starts when you have a position that goes against you. As it appears ‘red’ in your portfolio you start to worry. As it drops further you think ‘I wish I’d sold when I first started to worry.’ The worry stops increasing when it starts to bottoms out and starts to subside as it starts to rise. Then when it gets back to your buy price you are so relieved you immediately sell. This of course is a form of ‘anchoring’ and is illogical. If nothing has changed since you bought then the share price going down and up again has not changed the investment case. Equally if the investment case has deteriorated you should have sold immediately and it is merely chance that means you are back even. Again given the power of this effect it may be worth setting a rule that you never sell a share at your buy price. Particularly when the share price trajectory has been a drop and recovery on no news.

In Summary…

Given that behavioural biases are pervasive, hard to identify in real time and high impact it makes sense to have a strategy to deal with them. I believe the best solution is to create a sensible set of rules in advance, write them down, and apply them rigidly. This doesn’t mean you follow a purely rules based investment strategy but you proactively identify areas of weakness and think how applying a simple rule could overcome that. This frees you to spend your energy where you can have the greatest impact: finding great investments that no one else has spotted.

Wishing you all, correctly diversified, properly weighted portfolios free from behavioural bias.

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