Portfolio Management and Trading
Trading—the process of buying and selling securities—can have a significant impact on one’s investment results. Good trading decisions can sometimes add to an investment’s profitability and other times can mean the difference between executing a transaction and failing to do so. Portfolio management encompasses trading activity as well as the regular review of one’s holdings. In addition, an investor’s portfolio management responsibilities include maintaining appropriate diversification, making hedging decisions, and managing portfolio cash flow and liquidity.
All investors must come to terms with the relentless continuity of the investment process. Although specific investments have a beginning and an end, portfolio management goes on forever. Unlike many areas of endeavor, there is no near-annuity of profitable business, no backlog of upcoming investment returns. Heinz ketchup will have a reasonably predictable volume of sales years in and year out. In a sense, its profits of tomorrow were partially earned yesterday when its franchise was established. Investors in marketable securities will not have predictable annual results, however, even if they possess shares representing fractional ownership of the same company. Moreover, attractive returns earned by Heinz may not correlate with the returns achieved by investors in Heinz; the price paid for the stock, and not just business results, determines their return.
The Importance of Liquidity in Managing an Investment Portfolio
Since no investor is infallible and no investment is perfect, there is considerable merit in being able to change one’s mind. If an investor purchases a liquid stock such as IBM because he thinks that a new product will be successful or because he expects the next quarter’s results to be strong, he can change his mind by selling the stock at any time before the anticipated event, probably with minor financial consequences. An investor who buys a nontransferable limited partnership interest or stock in a non-public company, by contrast, is unable to change his mind at any price; he is effectively locked in. When investors do not demand compensation for bearing illiquidity, they almost always come to regret it.
Most of the time liquidity is not of great importance in managing a long-term-oriented investment portfolio. Few investors require a completely liquid portfolio that could be turned rapidly into cash. However, unexpected liquidity needs do occur. Because the opportunity cost of illiquidity is high, no investment portfolio should be completely illiquid either. Most portfolios should maintain a balance, opting for greater illiquidity when the market compensates investors well for bearing it.
A mitigating factor in the tradeoff between return and liquidity is duration. While you must always be well paid to sacrifice liquidity, the required compensation depends on how long you will be illiquid. Ten or twenty years of illiquidity is far riskier than one or two months; in effect, the short duration of an investment itself serves as a source of liquidity. Investors making venture-capital investments, for example, must be exceptionally well compensated to offset the high probability of loss, the large proportion of the investment that is at risk (losses are often complete wipeouts), and the illiquidity experienced for the duration of the investment. The cost of illiquidity is very high in such situations, rendering venture capitalists virtually unable to change their minds and making it difficult for them to cash in even when the businesses they invested in are successful.
Liquidity can be illusory. As Louis Lowenstein has stated, “In the stock market, there is liquidity for the individual but not for the whole community. The distributable profits of a company are the only rewards for the community.” In other words, while any one investor can achieve liquidity by selling to another investors, all investors taken together can only be made liquid by generally unpredictable external events such as takeover bids and corporate share repurchases. Except for such extraordinary transactions, there must be a buyer for every seller of a security.
In times of general market stability, the liquidity of a security or class of securities can appear high. In truth liquidity is closely correlated with investment fashion. During a market panic the liquidity that seemed miles wide in the course of an upswing may turn out only to have been inches deep. Some securities that traded in high volume when they were in favor may hardly trade at all when they go out of vogue.
When your portfolio is completely in cash, there is no risk of loss. There is also, however, no possibility of earning a high return. The tension between earning a high return, on the one hand, and avoiding risk, on the other, can run high. The appropriate balance between illiquidity and liquidity, between seeking return and limiting risk, is never easy to determine.
Investing is in some ways an endless process of managing liquidity. Typically, an investor begins with liquidity, that is, with cash that he or she is looking to put to work. This initial liquidity is converted into less liquid investments in order to earn an incremental return. As investments come to fruition, liquidity is restored. Then the process begins anew.
This portfolio liquidity cycle serves two important purposes. First, portfolio cash flow—the cash flowing into a portfolio—can reduce an investor’s opportunity costs. Second, the periodic liquidation of parts of a portfolio has a cathartic effect. For the many investors who prefer to remain fully invested at all times, it is easy to become complacent, sinking or swimming with current holdings. “Dead wood” can accumulate and be neglected while losses build. By contrast, when the securities in a portfolio frequently turn into cash, the investor is constantly challenged to put that cash to work, seeking out the best values available.
Reducing Portfolio Risk
The challenge of successfully managing an investment portfolio goes beyond making a series of good individual investment decisions. Portfolio management requires paying attention to the portfolio as a whole, taking into account diversification, possible hedging strategies, and the management of portfolio cash flow. In effect, while individual investment decisions should take risk into account, portfolio management is a further means of risk reduction for investors.
Even relatively safe investments entail some probability, however small, of downside risk. The deleterious effects of such improbable events can best be mitigated through prudent diversification. The number of securities that should be owned to reduce portfolio risk to an acceptable level is not great; as few as ten to fifteen different holdings usually suffice.
Diversification for its own sake is not sensible. This is the index fund mentality: if you can’t beat the market, be the market. Advocates of extreme diversification live in fear of company-specific risks; their view is that if no single position is large, losses from unanticipated events cannot be great. However, an investor is likely better off knowing a lot about a few investments than knowing only a little about each of great many holdings. One’s very best ideas are likely to generate higher returns for a given level of risk than one’s hundredth or thousandth best idea.
Market risk—the risk that the overall stock market could decline—cannot be reduced through diversification but can be limited by hedging. An investor’s choice among many possible hedging strategies depends on the nature of his or her underlying holdings. A diversified portfolio of large capitalization stocks, for example, could be effectively hedged through the sale of an appropriate quantity of S&P 500 index futures. This strategy would effectively eliminate both profits and losses due to broad-based stock market fluctuations. If a portfolio were hedged through the sale of index futures, investment success would thereafter depend on the performance of one’s holdings compared with the market as a whole.
A portfolio of interest-rate-sensitive stocks could be hedged by selling interest rate futures or purchasing or selling appropriate interest rate options. A gold-mining stock portfolio could be hedged against fluctuations in the price of gold by selling gold futures. A portfolio of import- or export-sensitive stocks could be partially hedged through appropriate transactions in the foreign exchange markets.
It is not always smart to hedge. When the available return is sufficient, for example, investors should be willing to incur risk and remain unhedged. Hedges can be expensive to buy and time-consuming to maintain, and overpaying for a hedge is as poor an idea as overpaying for an investment. When the cost is reasonable, however, a hedging strategy may allow investors to take advantage of an opportunity that otherwise would be excessively risky. In the best of all worlds, an investment that has valuable hedging properties may also be an attractive investment on its own merits.
The Importance of Trading
There is nothing inherent in a security or business that alone makes it an attractive investment. Investment opportunity is a function of price, which is established in the marketplace. Whereas some investors are company- or concept-driven, anxious to invest in a particular industry, technology, or fad without special concern for price, a value investor is purposefully driven by price. A value investor does not get up in the morning knowing his or her buy and sell orders for the day; these will be determined in the context of the prevailing prices and an ongoing assessment of underlying values.
Since transacting at the right price is critical, trading is central to value-investment success. This does not mean that trading in and of itself is important; trading for its own sake is at best a distraction and at worst a costly digression from an intelligent and disciplined investment program. Investors must recognize that while over the long run investing is generally a positive-sum activity, on a day-to-day basis most transactions have zero-sum consequences. If a buyer receives a bargain, it is because the seller sold for too low a price. If a buyer overpays for a security, the beneficiary is the seller, who received a price greater than underlying business value.
The best investment opportunities arise when other investors act unwisely thereby creating rewards for those who act intelligently. When others are willing to overpay for a security, they allow value investors to sell at premium prices or sell short at overvalued levels. When others panic and sell at prices far below underlying business value, they create buying opportunities for value investors. When their actions are dicatated by arbitrary rules or constraints, they will overlook outstanding opportunities or perhaps inadvertently create some for others. Trading is the process of taking advantage of such mispricings.
Stay in Touch with the Market
Some investors buy and hold for the long term, stashing their securities in the proverbial vault for years. While such a strategy may have made sense at some time in the past, it seems misguided today. This is because the financial markets are prolific creators of investment opportunities. Investors who are out of touch with the markets will find it difficult to be in touch with buying and selling opportunities regularly created by the markets. Today with so many market participants having little or no fundamental knowledge of the businesses their investments represent, opportunities to buy and sell seem to present themselves at a rapid pace. Given the geopolitical and macroeconomic uncertainties we are likely to continue to face in the future, why would abstaining from trading be better than periodically reviewing one’s holdings?
Being in touch with the market does pose dangers, however. Investors can become obsessed, for example, with every market uptick and downtick and eventually succumb to short-term-oriented trading. There is a tendency to be swayed by recent market action, going with the herd rather than against it. Investors unable to resist such impulses should probably not stay in close touch with the market; they would be well advised to turn their investable assets over to a financial professional.
Buying: Leave Room to Average Down
The single most crucial factor in trading is developing the appropriate reaction to price fluctuations. Investors must learn to resist fear, the tendency to panic when prices are falling, and greed, the tendency to become overly enthusiastic when prices are rising. One half of trading involves learning how to buy. Investors should usually refrain from purchasing a “full position” (the maximum dollar commitment they intend to make) in a given security all at once. Those who fail to heed this advice may be compelled to watch a subsequent price decline helplessly, with no buying power in reserve. Buying a partial position leaves reserves that permit investors to “average down,” lowering their average cost per share, if prices decline.
Evaluating your own willingness to average down can help you distinguish prospective investments from speculations. If the security you are considering is truly a good investment, not a speculation, you would certainly want to own more at lower prices. If, prior to purchase, you realize that you are unwilling to average down, then you probably should not make the purchase in the first place. Potential investments in companies that are poorly managed, highly leveraged, in unattractive businesses, or beyond understanding may be identified and rejected.
Selling: The Hardest Decision of All
Many investors are able to spot a bargain but have a harder time knowing when to sell. One reason is the difficulty of knowing precisely what an investment is worth. An investor buys with a range of value in mind at a price that provides a considerable margin of safety. As the market price appreciates, however, that safety margin decreases; the potential return diminishes and the downside risk increases. Not knowing the exact value of the investment, it is understandable that an investor cannot be as confident in the sell decision as he or she was in the purchase decision.
To deal with the difficulty of knowing when to sell, some investors create rules for selling based on specific price-to-book value or price-to-earnings multiples. Others have rules based on percentage gain thresholds; once they have made X percent, they sell. Still others set sale price targets at the time of purchase, as if nothing that took place in the interim could influence the decision to sell. None of these rules make good sense. Indeed, there is only one valid rule for selling: all investments are for sale at the right price.
Decisions to sell, like decisions to buy, must be based upon underlying business value. Exactly when to sell—or buy—depends on the alternative opportunities that are available. Should you hold for partial or complete value realization, for example? It would be foolish to hold out for an extra fraction of a point of gain in a stock selling just below underlying value when the market offers many bargains. By contrast, you would not want to sell a stock at a gain (and pay taxes on it) if it were still significantly undervalued and if there were no better bargains available.
Some investors place stop-loss orders to sell securities at specified prices, usually marginally below their cost. If prices rise, the orders are not executed. If the prices decline a bit, presumably on the way to a steeper fall, the stop-loss orders are executed. Although this strategy may seem an effective way to limit downside risk, it is, in fact, crazy. Instead of taking advantage of market dips to increase one’s holdings, a user of this technique acts as if the market knows the merits of a particular investment better than he or she does.
Liquidity considerations are also important in the decision to sell. For many securities the depth of the market as well as the quoted price is an important consideration. You cannot sell, after all, in the absence of a willing buyer; the likely presence of a buyer must therefore be a factor in the decision to sell.
While individual personalities and goals can influence one’s trading and portfolio management techniques to some degree, sound buying and selling strategies, appropriate diversification, and prudent hedging are of importance to all investors. Of course, good portfolio management and trading are of no use when pursuing an inappropriate investment philosophy; they are of maximum value when employed in conjunction with a value-investment approach.