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Portfolio Management - The Dos and Don'ts

Editor, TRANSFIN
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Everyone knows what portfolio management is. But this article is different, for it presents

A different and simpler take at it. I will be specifically focusing on a stock market portfolio

to simplify the explanation.

Deciding which stock to buy is just half the work done. Portfolio management is the

second half.

Quite opposite to those money managers, I don’t believe in the need to be perplexed by

looking at a gazillion computer screens at once and noting the minute-by-minute

changes.

We shouldn’t think in minutes or days or months, We must think in years. There is no

scope in investing in 100 shares, the magic lies in investing in a few outstanding

companies. Note – companies not share. “FOCUS INVESTING” as it is called Simplifies

the horrendous task of portfolio management to a great extent.

 A TALE OF TWO

Currently the two widely used and rather compelling portfolio management-

 Active portfolio and

 Index investing

Now, Active portfolio management involves buying and selling a lot of common stocks

and predicting how they will perform in 6 months thus consistently outperforming the

Market so that on applying the obvious barometer – how well does my portfolio do when

Compared to the market overall – the answer is positive.

On the other hand, the passive approach - index investing involves buying and holding a

broad and diversified portfolio of stocks designed to mimic the behaviour of a specific

benchmark index. The most commonly used and straightforward means to achieve this is

Investing in index mutual funds. Active portfolio managers argue that, by virtue of their

superior stock-picking skills, they can do better than any index. But through history, we

can say that fate has decided against it. Almost 70% of the actively managed mutual

funds underperformed against the BSE over the last 10 years. Index investors can do no

worse than the market, and also no better.   

Active portfolio management fails majorly due to its fundamentals being established on

the Shakey premises of prediction. The fatal flaw in that logic is that given the complexity

of the financial universe, predictions are impossible. Indexing is better than an active

portfolio, especially for people with low-risk tolerance and also the ones who don’t know

much about investing and business but want to gain profit from investing.

As Warren Buffets says “By periodically investing in an index fund, the know-nothing

investor can actually outperform most investment professionals.”

There is a third type of investing too, Focus investing

 

FOCUS INVESTING

Focus investing is all about choosing a few stocks that are likely to produce above-

average returns over a longer duration of time, then concentrating  a big chunk of your

investments in those stocks, and having the resilience to hold steady through any short-

term market ups and downs.

The logic behind it is: If the company is doing fine and is managed by efficient people,

eventually its stock price will reproduce its inherent value. Thus one must devote most of

his attention not to analysing share price but to analysing the business and evaluating its

management.

 

THE FOCUS INVESTOR’S GOLDEN RULES (by Warren Buffett)

 1. Concentrate your investments in outstanding companies run by strong management.

 2. Limit yourself to the number of companies you can truly understand. Ten to twenty is

good, more than twenty is asking for trouble.

3. Pick the very best of your good companies, and put the bulk of your investment there.

 4. Think long-term: five to ten years, minimum.

 5. Volatility happens. Carry on

 

WHY DOES BUFFETT BELIEVE IN LESS IS MORE

“I can’t be involved in 50 or 75 things. That’s a Noah’s Ark way of investing—you end up

with a zoo. I like to put meaningful amounts of money in a few things.”

                                                                                  WARREN BUFFETT, 1987

Although for know-nothing investor buffet advises—to stay with index funds

For people who do have an idea, he says: “If you are a know-something investor, able to

understand business economics and to find five to ten sensibly-priced companies that

possess important long-term competitive advantages, conventional diversification

(broadly based active portfolios) makes no sense for you.”

Why is he so against diversifications? What's so wrong with it?

Certainly, one thing significantly increases the chances that you will end up buying

something you don’t require and know enough about. Even the most seasoned investors

of modern finance have discovered that, on average, just 15 stocks give you 85%

diversification.

“With each investment you make, you should have the courage and the conviction to

place at least ten percent of your net worth in that stock,” Buffett says. Certainly, all the

stocks in a focused portfolio are high-probability events, some will unescapably be higher

than others, thus must be assigned a greater proportion of the invested money.

 

Patience Is The Key

Focus investing is the antithesis of a broadly diversified high-turnover approach.

Although focus investing has the best chance among all active strategies of

outperforming an index return over time, it requires a lot of patience, investors must

patiently hold their portfolio even if the other strategies seem to be winning.

How long is long enough?

As a general rule of thumb, we should aim for a profit between 10-20%, which implies

holding for 5-10 years.

 

Panicking over price change is what’s making you loose

If you have invested in a good company you don’t need to mind the price bumps. You

must and will have to teach yourself not to get baffled and act hastily in response to the

whims of the market. This is what sets you apart. Warren Buffett as a notion believes that

a price drop in share prices is a money-making chance. In his mind price dip equals

reduced risk, “For owners of a business—and that’s the way we think of

Shareholders—the academics’ definition of risk is far off the mark, so much so that it

produces absurdities.” If you buy a stock today and intend to sell it tomorrow, you have

arrived into a risky transaction.

 The odds of foreseeing if the share prices will be up or down in such a short time period

are the same as the odds of predicting the toss of a coin; you will lose half of the time,

but if you extend your time frame to several years (after making a sensible purchase)

then the odds shift in your favour.

 

KEEP MAKING CHANGES IN YOUR PORTFOLIO

Making a tough call – Should I buy?

Add an investment only and only when it's any better than the others you have. No one

could explain it better than Charlie Munger –

“For an ordinary individual, the best thing you already have should be your measuring

stick. If the new thing you are considering purchasing is not better than what you already

know is available, then it hasn’t met your threshold. This screens out 99 percent of what

you see.”

Making Another Tough Call – Should I Sell?

While selling, it’s a good strategy to move slowly. You can hold the share as long as the

company continues to produce above-average economics and management distributes

the earnings of the company in a rational manner.

If the shares you own are from a crummy company there is no use in holding them. But if

you own a superior company, the last you would want to do is sell it.

This sloth-like approach has other benefits too like reducing transaction costs and

increasing after-tax returns.

 

 

Challenges Of This Approach

Putting it plainly, the major unavoidable repercussion of this method is heightened

volatility. Focusing portfolio on a small number of companies will lead to a noticeable

impact even if there is a change in prices of one company. 

The most vital ability for both your peace of mind and financial success is to be able to

withstand volatility without having a cold foot.

But we run into a problem here – the emotional side effect of investing. Money matters

are about the most emotional subjects of all. The key is to keep your emotions in

appropriate perspective, not be constantly at the mercy of those emotions to the point

That sensible action is handicapped.