Markets are Competitive

Passive Management

Holding a highly diversified portfolio

No attempt to find undervalued securities

No attempt to time the market.

Active Management

Finding mispriced securities

Timing the market

Monitoring your portfolio using Excel file.

Process of Portfolio Management

 

Capital Market Expectations

To help investors assess the potential investment returns and determine the long-term outlook, formulate expectations for risk and return of various asset classes.

Asset Allocation Strategy

There are two strategies to consider here, strategic and tactical. 

A strategic asset allocation strategy is a long-term strategy that necessitates regular rebalancing to ensure you do not deviate from your goals.

A tactical asset allocation strategy, on the other hand, takes a more active approach that reacts to changing market conditions. This means that despite having a long-term plan, you make frequent changes for short-term gains.

Feedback

Any changes are thoroughly examined to ensure they are consistent with long-term objectives.

Monitoring and Rebalancing

A portfolio manager should regularly monitor and evaluate risk exposures within the portfolio to rebalance it according to the strategic asset allocation.

Performance Evaluation

Evaluating a portfolio using absolute and relative returns gives a complete picture of its strengths and weaknesses. Such help portfolios reach their full potential and give investors the confidence that their funds are managed well.

https://www.financestrategists.com/financial-advisor/portfolio-management/#:~:text=There%20are%20four%20main%20portfolio,educated%20choice%20about%20an%20investment.

Strategies of Portfolio Management.

 

https://www.financestrategists.com/financial-advisor/portfolio-management/#:~:text=There%20are%20four%20main%20portfolio,educated%20choice%20about%20an%20investment.

Diversification; Goal is to lower portfolio volatility without sacrificing overall returns

This strategy helps reduce the risk profile of an investment as it spreads out the portfolio over multiple asset classes or sectors.

The goal of diversification is to lower portfolio volatility without sacrificing overall returns. In this way, investors can benefit from holding a combination of stocks and bonds, as asset classes tend to perform differently in varying market conditions.

Major role of portfolio management: minimize risks and maximize returns

Investment portfolio management is a crucial part of any long-term investment strategy, as it plays a major role in helping individuals and organizations to minimize risks and maximize returns.

Rebalancing

Rebalancing is a strategy that regularly reassesses the asset allocation and cash holdings in a portfolio according to predetermined goals.

This helps keep the composition of a portfolio in line with its objectives, such as capital growth or income generation, and helps minimize risk exposure and take advantage of new opportunities.

By reviewing different types of investments within an overall portfolio and shifting money from sections that have exceeded their target proportions back into those that have dipped below them, savvy investors can work to maintain optimum performance over time.

Portfolio Management

Portfolio management is the process of creating and maintaining a well-diversified collection of investments that align with an individual's financial goals and risk tolerance.

These include monitoring performances, setting goals, analyzing risk factors, and devising investment strategies.

There are four main portfolio management types: 

• active, 
• passive, 
• discretionary, and 
• non-discretionary.

A successful portfolio management process involves careful planning, execution, and feedback.

Investment strategies can assist investors in making an educated choice about an investment. The key strategies involved in portfolio management are 

• asset allocation, 
• diversification, 
• rebalancing, and 
• tax minimization.

Consider speaking with a financial advisor who can assist you in analyzing your investment needs and developing an investment plan, should you not be in a position to do so yourself.

https://www.financestrategists.com/financial-advisor/portfolio-management/#:~:text=There%20are%20four%20main%20portfolio,educated%20choice%20about%20an%20investment.

Portfolios and Selling

#Good company gets inexpensive, how much to buy?

When an understood, good company gets inexpensive, we buy its stock. But how much?

(1)  Enough uninvested cash (CASH)
My rule is simple. Provided that I have enough uninvested cash, I put 10 percent of the portfolio in it. I’ve seen other good investors use infinitely more complicated guidelines, but none that I’ve found to be more practical.

If I’m not comfortable putting at least a tenth of the portfolio into an equity, I don’t want the equity. If my conviction is lower I don’t buy less, I buy none.

(2)  Strong conviction (COURAGE)
A strong conviction is important in part because right after a buy the price of a stock is almost certain to drop. That’s the corollary to another near-certainty: that the price paid for a stock is unlikely to be a low. Rock-bottoms don’t send out invitations. So knowing when one will happen is impossible. The astute investor counts on missing them.

Correspondingly, I prefer not to put more than a tenth of the portfolio into a single equity. This reduces the chance that I’ll lack the cash necessary to take advantage of other opportunities that emerge.



#Buying is one aspect of portfolio construction. Another is selling.

There are two problems with selling. 

1.  The first is taxes. 

The profitable sale of stock is taxable in most circumstances. Just how much this eats into long-term returns is best illustrated by example.

Picture two portfolios. Each starts with only cash, buys only non-dividend paying stocks, and liquidates after 30 years. Assume that any stock sales are subject to a total long-term capital gains tax rate of 30 percent.

Portfolio one uses all its cash to buy stock on the first day. It appreciates 15 percent before taxes every year. It doesn’t sell anything until the liquidation date, at which point it immediately pays any taxes due.


Portfolio two also uses all its cash to buy stock on the first day. It too appreciates 15 percent per year before taxes. But it churns its holdings annually. At the end of every year, it sells everything, and uses all the after-tax proceeds to instantly buy different stocks. When it liquidates after 30 years, it too promptly pays any taxes due.

Portfolio one would end the 30-year period with more money. But what’s striking is just how much more. It would wind up with over twice as much cash. That’s because every year when portfolio two paid its capital gains taxes, it whittled down the amount set to grow at 15 percent over the following year. In other words, ongoing tax payments stunted the power of compounding.

By contrast, portfolio one’s capital was never whittled down. It regularly got to multiply its 15 percent by a bigger number:

http://www.goodstockscheap.com/17.1.xlsx

Of course one could never count on an equity portfolio to appreciate at exactly 15 percent annually, and the chance of immediately finding stocks to replace just-sold ones is low. Plus the 30-year period is arbitrary, and a 30 percent tax rate doesn’t apply to everyone. But however simplified, this example
highlights the toll that frequent selling takes.


2.  The second problem with selling is alternatives. 

Companies that are understood and good don’t go on sale every day. They’re hard to find. So absent an acute cash requirement, each stock sale mandates a hunt for the next opportunity.



#When selling makes sense

Even with these problems, selling does makes sense in some instances. I see four.

(a)  The first is when price flies past value. 
If EV/OI is over 25, and there are no mitigating facts, I find it hard to justify holding.

(b) The second instance is when a company that originally registered as good turns out not to be. 
This could be because the original analysis was wrong. Perhaps the threat of new entrants was stronger than it first appeared, or a market thought to be growing really wasn’t. Or it could be because circumstances have changed. Maybe a once-mighty retail chain has come under pressure from online-only sellers, or a company that thrived under regulation has faltered in deregulation.

The cognitive bias of consistency can make it hard to see such instances. We may want to hold just to validate our buys. But analyses really can be wrong, and contexts really can change. Selling in such situations keeps a snag from ripping into both a realized loss and a missed chance to redeploy cash into a better opportunity.

(c)  The third instance is when one is bought out. 
Public companies sometimes get acquired. Such transactions often happen at a premium to the recent trading price. A vote may be put to shareholders on the matter, but for everyone other than major stakeholders, it’s perfunctory. One effectively has no say.

I’ve been bought out several times. I dislike it. It turns a pleasantly appreciating investment into a taxable event. But if profitable, given the absence of practical options, it makes sense to accept such sales.

(d)  The fourth instance is when cash is needed to make an investment that’s clearly better than one already held. 
The problem with this is that fresh ideas often glow with a special promise. They’re new. The hope bias gets a prime shot at causing mischief. As such, I get extremely suspicious of my reasoning when I think that I’m spotting such a circumstance. I’ve never actually sold one company for the specific purpose of buying another.



#When selling makes no sense

Two commonly cited reasons for selling puzzle me.

1.  One is rebalancing. 
It’s selling part of a stock holding because appreciation has caused it to represent a disproportionately large percentage of the portfolio.

Rebalancing makes sense to those who equate risk with total portfolio volatility. I don’t. So on the sell side, I’ve never seen the merits of this practice.

It makes more sense to me on the buy side, since unless part of a holding was sold, a decrease in its portfolio prominence means that its price dropped. One could now buy more of it cheaper. But on the sell side rebalancing looks to me like the anchoring bias in action.

2.  A second common reason for selling is to prove that an investment was a success (taking profits). 
The sale is seen as a sort of finish line. Underlying this perception is a view that cash is somehow more real than stocks.

It’s not. Cash and stocks are different forms that wealth can take. Unrealized gains are not endemically less concrete than realized gains. Selling doesn’t demonstrate investing competence any better than does intelligent holding.


Yet another reason for selling is Industry compensation
There’s an additional reason that selling happens. It relates only to institutional portfolios, like hedge funds. It’s about compensation.

Investment funds often pay managers 2 percent of assets under management per year, plus 20 percent of any gain above some hurdle. That 20 percent is applied to pretax returns. It’s blind to taxes. For this reason professionals may emerge as more enthusiastic about selling than would their limited partners. After all, unless they’re tax-exempt, the limited partners are the ones that come to bear the bulk of the tax liabilities born of the fund’s realized gains.

One faces great impetus to sell. It feels good. It’s conclusive. It turns the brokerage statement into a congratulations card. But it also triggers a tax expense and—short of a pressing need for cash—forces a search for the next underpriced equity.

When a sale is wise, its justification is distinct. It’s an overpricing, an analytical error, a contextual change, a buyout, or a better opportunity. Absent that clarity, I hold.



#Equity portfolio can generate cash through buyouts and dividends
Even without active selling, an equity portfolio can generate cash. It can do so in two ways.

1.  The first is through acquisitions, as mentioned earlier.

2.  The second is through dividends. 
Dividends can become sizable. This fact gets lost in the commonly quoted metric of dividend yield.

Recall that dividend yield equals annual dividends divided by current stock price. But to an owner, current only counts in the numerator.

When I first bought Nike stock, the dividend yield was around 2 percent. Over a decade later when I sold it, it was still around 2 percent. But by then my dividend yield—the current annual dividend divided by the price I’d paid for the stock—was closer to 10 percent. Dividends had gone up over time, but my cost hadn’t. That’s how dividends can become a booming cash source underappreciated by all but those who get them.



#Over time, good focused (concentrated) stock portfolios outperform diversified portfolios.
Remember that my portfolio is concentrated. It contains no more than a dozen names, and usually far fewer. On purpose, it’s not diversified. Many good equity portfolios are, but mine isn’t.


1.  Good focused portfolio versus diversified portfolio
I choose to concentrate because I’ve observed over time that good, focused stock portfolios outperform diversified stock portfolios. This is because diversified portfolios are more like an index. They have more names in them. The more a portfolio looks like an index, the more it behaves like an index. It’s hard to both resemble and outperform something.


2.  Bad focused portfolio versus diversified portfolio
Of course a bad focused equity portfolio can certainly lag a diversified stock portfolio.

Concentration isn’t enough to assure outperformance. But if it’s purposefully constructed, a focused group of inexpensively bought good companies is particularly promising.



#Sequestered Cash outside of the equity portfolio for  ordinary expenses 
While I don’t diversify within my equity portfolio, I do diversify outside of it. I always keep enough cash on hand to cover expenses for a few years. As I get older, I expect to increase this number of years.

1.  In Federally insured banks
This isn’t cash inside the equity portfolio waiting to be invested in stocks. It’s cash outside of the equity portfolio, held in federally insured banks. It will never be anything other than cash or spent.

Sequestering cash enables me to confidently ride the wild price swings guaranteed to come with a concentrated equity portfolio. It’s what lets me take the long view. When the price of my stock portfolio halved during the 2008 financial crisis, I didn’t panic. I knew that I could meet all of my expenses. There was no basis for panic.

Many governments insure bank deposits. Coverage varies by country. In America, the Federal Deposit Insurance Corporation generally guarantees up to $250,000. In the United Kingdom, the Financial Services Compensation Scheme stands behind £75,000. In Canada, the Canada Deposit Insurance Corporation backs C$100,000.

Because the whole point of sequestered cash is to avoid the scare that forces ill-timed stock sales, it’s wise to stay well under the insured limit. Opening up accounts at several different banks is not hard.


2.  In same currency as one's expenses Sequestered cash is best held in the same currency as one’s expenses. If it isn’t, foreign exchange rate fluctuations can hurt one’s ability to meet obligations.

As I write this, the British pound has slumped to a 30-year low against the U.S. dollar. This follows Britain’s decision to leave the European Union.1 Some American investors think the slump is overdone and have invested in the British pound.

To people whose expenses are in U.S. dollars, those pounds don’t count as sequestered cash. Instead, they count as a currency investment.



#These repositories for sequestered cash aren't really good
Two things that may look like good repositories for sequestered cash really aren’t.

1.   The first is certificates of deposit, or CDs. 

Outside of the United States they’re commonly called time deposits. They offer higher interest rates than do regular bank accounts. Money must stay in them for a predetermined period. If it’s withdrawn early, a penalty is applied that more than wipes out the extra interest.

If the CD interest rate is much higher than the regular interest rate, one could theoretically keep a portion of sequestered cash in CDs. The portion would have to be limited to that which shouldn’t be needed for the duration of the lockup period.

That said, I don’t use CDs. Since the timing of cash needs can surprise, I prefer to keep the focus of sequestered cash on costless accessibility.

2.   The other repository is cash-like funds (commercial paper). 
They too offer higher interest rates. An example is a fund that invests in commercial paper. Commercial paper is short-term notes issued by corporations.

Such cash-like vehicles usually behave like cash. One can pay bills with them. But I’ve seen instances when they don’t. During the financial crisis, an acquaintance of mine was surprised to learn that her financial institution had temporarily halted withdrawals from such a fund. She couldn’t make payments with it.

This potential—the inability to immediately liquidate—is the problem with these alternatives. The purpose of sequestered cash is to free one from worry during equity market gyrations. If what’s used for expenses ever can’t be used for expenses, that benefit is lost. One can wind up having to sell part of an equity portfolio when it’s underpriced, erasing the benefits of stock investing.


#Problems with cash
Cash has its own problems, of course. Inflation erodes its purchasing power over time. Expansionary monetary policies—governments printing money— exacerbate this. But if held in government-insured accounts under applicable limits, at least it’s always there. That availability is what makes the interim ups and downs of an equity portfolio’s price not only bearable, but almost trivial.





Summary
1. Conviction prepares one for the likely price drop that follows a stock buy.
2. Selling stocks can make sense 

• price flies past value, 
• when a company thought to be good turns out not to be, 
• in buyouts, or 
• when a clearly better opportunity emerges.

3. The problems with selling are taxes and alternatives.
4. Questionable reasons for selling include 

• rebalancing, 
• memorializing success, and 
• industry compensation.

5. Equity portfolios can generate cash without active selling through 

• buyouts and 
• dividends.

6. Good focused equity portfolios outperform diversified equity portfolios over the long term.
7. Cash sequestered for ordinary expenses in government-insured accounts makes equity portfolio price gyrations less troubling.


Reference:

Good Stocks Cheap by Kenneth Jeffrey Marshall 2017

Good Portfolio Management and Trading are of maximum value when used with an Appropriate Investment Philosophy

Here are a number of issues that investors should consider in managing their portfolios.

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.

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. 



1.  Appropriate Diversification 

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 - which I think of as overdiversification - live in fear of company-specific risks; their view is that if no single position is large, losses from unanticipated events cannot be great. 
• My view is that an investor is better off knowing a lot about a few investments than knowing only a little about each of a 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. 

Diversification is potentially a Trojan horse. 

• Junk-bond-market experts have argued vociferously that a diversified portfolio of junk bonds carries little risk. Investors who believed them substituted diversity for analysis and, what's worse, for judgment. 
• The fact is that a diverse portfolio of overpriced, subordinated securities, about each of which the investor knows relatively little, is highly risky. 
• Diversification of junk-bond holdings among several industries did not protect investors from a broad economic downturn or credit contraction. 
• Diversification, after all, is not how many different things you own, but how different the things you do own are in the risks they entail. 

2.  Hedging 

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 Standard & Poor's 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. 

By way of example, from mid-1988 to early 1990 the Japanese stock market rose repeatedly to record high levels. The market's valuation appeared excessive by U.S. valuation criteria, but in Japan the view that the stock market was indirectly controlled by the government and would not necessarily be constrained by underlying fundamentals was widely held.

• Japanese financial institutions, which had become accustomed to receiving large and growing annual inflows of funds for investment, were so confident that the market would continue to rise that they were willing to sell Japanese stock market puts (options to sell) at very low prices. 
• To them sale of the puts generated immediate income; since in their view the market was almost certainly headed higher, the puts they sold would expire worthless. 
• If the market should temporarily dip, they were confident that the shares being put back to them would easily be paid for out of the massive cash inflows they had come to expect. 

Wall Street brokerage firms acted as intermediaries, originating these put options in Japan and selling them in private transactions to U.S. investors.' These inexpensive puts were in theory an attractive, if imprecise, hedge for any stock portfolio.

• Since the Japanese stock market was considerably overvalued compared with the U.S. market, investors in U.S. equities could hedge the risk of a decline in their domestic holdings through the purchase of Japanese stock market puts. 
• These puts were much less expensive than puts on the U.S. market, while offering considerably more upside potential if the Japanese market declined to historic valuation levels. 

As it turned out, by mid-1990 the Japanese stock market had plunged 40 percent in value from the levels it had reached only a few months earlier.

• Holders of Japanese stock market put options, depending on the specific terms of their contracts, earned many times their original investment. 
• Ironically, these Japanese puts did not prove to be a necessary hedge; the Japanese stock market decline was not accompanied by a material drop in U.S. share prices. 
• These puts were simply a good investment that might have served as a hedge under other circumstances.

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 nonpublic 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 trade-off 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 anyone investor can achieve liquidity by selling to another investor, 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 tum into cash, the investor is constantly challenged to put that cash to work, seeking out the best values available.

Portfolio Management and Trading

Investing would be complete without a discussion of trading and portfolio management.



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

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. 




Investors in marketable securities will not have predictable annual results

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 year 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.

Managing Portfolio Cash Flow. Cash is the most Important determinant of Opportunity Cost

Most important determinant of opportunity cost:  Cash portion of your portfolio

If you hold cash, you are able to take advantage of opportunities during market declines.

If you are fully invested when the market declines, your portfolio will likely drop in value, depriving you of the benefits arising from the opportunity to buy in at lower levels.

This creates an opportunity cost, the necessity to forego future opportunities that arise.

If what you hold is illiquid or unmarketable, the opportunity cost increases further; the illiquidity precludes your switching to better bargains.

The most important determinant of whether investors will incur opportunity cost is whether or not part of their portfolios is held in cash.

Maintaining moderate cash balances or owning securities that periodically throw off appreciable cash is likely to reduce the number of foregone opportunities.



Managing portfolio cash flow

Investors can manage portfolio cash flow (defined as the cash flowing into a portfolio minus outflows) by giving preference to some kinds of investments over others.

Portfolio cash flow is greater for securities of shorter duration (weighted average life) than those of longer duration.

Portfolio cash flow is also enhanced by investments with catalysts for the partial or complete realization of underlying value.

Equity investments in ongoing businesses typically throw off only minimal cash through the payment of dividends.

The securities of companies in bankruptcy and liquidation, by contrast, can return considerable liquidity to a portfolio within a few years of purchase.

Risk-arbitrage investments typically have very short lives, usually turning back into cash, liquid securities, or both in a matter of weeks or months.

An added attraction of investing in risk-arbitrage situations, bankruptcies, and liquidations is that not only is one's initial investment returned to cash, one's profits are as well.



Hedging

Another way to limit opportunity cost is through hedging.

A hedge is an investment that is expected to move in a direction opposite that of another holding so as to cushion any price decline.

If the hedge becomes valuable, it can be sold, providing funds to take advantage of newly created opportunities. 

Some Ideas on Managing Portfolios

Portfolio management is more than the sum of the purchase of attractive stocks.

Here is a view on the overall lines of action on managing portfolio:

• The first step (optional) involves trying to acquire some idea about where we are in the cycle.
• Diversification
• Stock selection should be bottom-up.
• Pay particular attention to the weight of stocks in the portfolio.
• Changing weights.
• Sectoral efforts.

1. Where are we in the cycle? (Optional)

This involves trying to acquire some idea about where we are in the cycle.

Should we be moving towards defensive stocks, or - on the contrary - starting to be more aggressive, if we judge the declines to have been sufficient?

It is helpful to analyse the message coming from the types of stocks that interest us, so as to draw the right conclusions about what is going on. If some stocks in a sector have taken a particular hammering, it is likely we will be at the bottom of the cycle in that sector.

Overall market developments will also give us some insights. If there have been lots of very strong rises, we will be heading towards the end of a cyclical expansion, while after a series of large losses, we will doubtless be close to the bottom.

However, there is no guarantee that our analysis of the cycle will be successful.

If we are able to have some degree of clarity on the overall or sectoral cycle, then the next step is to consider which types of stocks will us in this context.

We need to buy the most aggressive stocks during low points in the cycle, even if it can be challenging to overcome the mental barriers to do so in such a negative environment. And vice-versa at the top of the cycle.

Designing the appropriate strategy for the general or sector cycle can be what adds most value to a portfolio.



2 Diversification

Our portfolio should be prepared to withstand any situation, be it a market collapse or a boom, inflation or deflation, for all possibilities. It must be agile and resilient against any eventuality.

We also have to insulate the portfolio from our own errors, whether they be our view of the cycle or our choice of companies. We have to envisage how our portfolio would be affected by the opposite scenario to what we are expecting; how it would survive.

Diversification is the clearest way to prepare the portfolio for any eventuality. Having at least 10 stocks gives us a reasonable amount of diversification. If we are managing on behalf o others, it can be helpful to hold a few more, creating a portfolio of some 20 - 30 stocks. After that, there need to be strong arguments for increasing the number of stocks.


3. Stock selection should be bottom-up.

Stock selection is the first step in managing portfolios. Avoid wasting time on companies which do not stand up to greater scrutiny. It is also important to be very flexible: avoiding slipping into generic asset allocation, both for sectors and regions. If we don't understand a certain business or new technologies, it is best to avoid them.


4. Pay particular attention to the weight of stocks in the portfolio.

Over the years, we got it wrong on a number of stocks. We must be very sure of our investment if we are going to assign it a high weight in our fund, never doing so if the company is indebted.

It is extremely difficult to discern and accept investment errors: we always end up giving the benefit of the doubt to the company, since after investing so much time studying it, we find it deeply unsatisfying to sell and think that we are throwing it away. One of the ways to get around this problem is by only having small exposures to the more dubious stocks.


5. Changing weights.

One of the ways to add value in asset management is by changing the size of positions in stocks. The argument for continually adjusting is one of simple probabilities: if a stock in a portfolio rises by 10% and another falls by 10%, then there has been a relative movement of 20% which we can capitalize on. The logical thing to do, once we have studied the movements, is to lower our position in the stock that has gained value and increase it in the one that has fallen.

Some investors prefer to wait until the stock has reached the target price before offloading the entire position, or take other approaches. However, it is highly likely that our simple approach increases the potential of the fund, since it is unlikely the valuations of the particular shares have moved in the same proportion.


6. Sectoral effort.

We should focus on attractive sectors. it is impossible to be on top of every sector. As unspecialised generalists we should discriminate between sectors that are worth following - which form the focus of our efforts - while leaving the rest to one side. Not all sectors are equally attractive all the time, and it take years for the level of interest to shift.

We should devote the bulk of our resources, especially time, to the most attractive sectors. We should keep an eye on other sectors, being aware of their existence, but they should not eat up our time for the moment. By moving from less attractive to more attractive sectors we avoid wasting time, which is an extremely scarce resource in investment analysis. There will be time in the future to return to sectors left to one side.

Always write down the reasons, pro and con, before making a purchase or a sale

Tip to the Investors:  Always Write it Down

Writing down your reasons for making an investment should save you in your investing.

What you expect to make?
What you expect to risk?
The reasons why?

Always write down the reasons, pro and con, before making a purchase or a sale.

• Major successes in some investors were invariably preceded by a type of written analysis.  
• Sudden emotional decisions have generally being disappointments.
• Writing things down before you do them can keep you out of trouble.  
• It can bring you peace of mind after you have made your decision.
• It also gives you tangible material for reference to evaluate the whys and wherefores of your profits or losses.

Quality Not Quantity

I have seen many analyses, some involving many pages of information.

In practice, quantity doesn't make quality.  

There is invariably one ruling reason why a particular security transaction can be expected to show profit.

• Writing it down will help you find it.
• It will help you judge whether it is really as important as your first inclination suggests.

Are you buying just because something "acts well"?

Is it a technical reason - 

• a coming increase in earnings or dividend not yet discounted in the market price, 
• a change of management,
• a promising new product, 
• an expected improvement in the market's valuation of earnings?

In any given case you will find that one factor will almost certainly be more important than all the rest put together.



Reward/Risk Ratio

Writing it down will help you estimate what you expect to make and it is important that this be worthwhile.

Of course, you will want to decide how much you can afford to lose.

There will be a level at which you will decide that things have not worked out and where you will sell.

Your risk is the difference between your cost and this sell point; it ought to be substantially less than your hopes for profit.

You certainly want to feel that the odds as you see them are in your favour.



Much More Difficult:  When to Sell

All this self-interrogation will help you immeasurably in the much more difficult decision:  when to close a commitment.

When you open a commitment, whether it is a purchase or a short sale, you are, so to speak, on your home ground.  Unless everything suits you, you don't play.

But when you are called upon to close a commitment, then you have to make decisions, whether you see the answer clearly or not (analogy:  being stuck on a railway crossing with the train approaching).

• You don't know what to do -but you have to do something.  
• Go backward, go forward - or jump out.

If you know clearly why you bought a stock it will help you to know when to sell it.  

• The major factor which you recognized when you bought a security will either work out or not work out.  
• Once you can say definitely that it has worked or not worked, the security should be sold.

One of the greatest causes of loss in security transactions is to open a commitment for a particular reason, and then fail to close it when the reason proves to be invalid.

• Write it down and you will be less likely to find yourself making irrelevant excuses for holding a security long after it should have been sold.
• Better still, a stock well bought is far more than half the battle.

Switching Capital: Replace 10% of your diversified investments annually

These are three grim factors that can damage your investment performance:

• the wrong industry, 
• a weak management and 
• over-market pricing of transient growth or profits - 

Are you fast enough to switch capital?

Capital is like a rabbit - it darts away at the first sign of danger!

Are you certain you watch your capital closely enough to flee from smoke before it becomes fire?

To do this successfully you must not only be alert to change but ready and willing to act.




Keep your eyes on the businesses

It is up to you as an investor to

• watch the progress of your companies and 
• switch your investments if your managements fail to keep up with the changing time.  

It takes superior management to adopt to change.  

It takes superior management to build worthy successors to follow in their footsteps.




Replace 10% of your diversified investments annually

Investors should make a conscious effort to do some switching in their portfolios. 

I think at a minimum they could switch 10% of a list of diversified investments annually.

If you own 20 stocks, surely replacing 2 can only help in keeping your investment in step with constantly changing investment factors.

Additional notes:

Newsletters of the First National City Bank of New York.

It tabulated the changes which occurred among the hundred largest U.S. manufacturers between 1919 and 1963.

These largest corporations are not always the most profitable.

Sheer size gave no guarantee of profitability or permanence.

While almost invariably at some stage in their growth, these companies were attractive investments, there was danger if you overstay your market.

1919 list:   100 largest U.S. manufacturers

1963 list:   Only 49 left

Comparison of just these two dates ignored the turnover.  In the interim numerous firms entered and left the group.

Many companies produced a single spurt of growth which could not be sustained.

Many factors were responsible.  An unfavourable change in the outlook for their industries was the major cause.

It boiled down to the always prime factor of management.

The greatest changes were in transportation companies.  It was asking too much to profit from selling horses and buggies in a gasoline age.

The National City letter concluded that to achieve success and hold it, 

• corporations must secure a primary position in growing markets, and, 
• they must be adoptable enough to shift into new fields and open up and to fill new needs.

It is up to you as an investor to watch the progress of your companies and switch your investments if your managements fail to keep up with the changing times.

None Since 96!  (Morgan Guaranty survey of stocks in Dow Averages since 1896)

A Morgan Guaranty survey compared the stocks that had been part of the Dow Averages since 1896.

Continual evolution, shifting investor preferences and the alterations in the actual composition of business activity resulted in not a single issue remaining on the list for the entire 68-year period.

Only American Tobacco and General Electric were on the 1912 and 1964 list, but both were on and off several times.

One of the least reliable guides to investing is popularity.  

• The transportation industry at that period contributed many once-popular investments that had vanished and had all but done so.  
• The carnage in streetcar lines and other utilities had been enormous.  
• Likewise in early automobile leaders.

Investors should make a conscious effort to do some switching in their portfolio.

The three reasons that can damage your investment performance are the wrong industry, a weak second echelon in management and over-market pricing of transient growth or profits.

Portfolio Weighting

It is important to know:

1.  how many stocks to own in your portfolio, and also,
2.  the percentage of your portfolio occupied by each stock.

A good investor has a knack for having a greater percentage of their money in stocks that do well and a lesser amount in their bad picks.


How does he do it?

Essentially, a portfolio should be weighted in direct proportion to how much confidence you have in each pick.

If you have a lot of confidence in the long term outlook and the valuation of a stock, it should be weighted more heavily than a stock than a stock you may be taking a flier on.


Weight your portfolio wisely.

Don't be too afraid to have some big weightings, but be certain that the highest-weighted stocks are the ones you feel the most confident about.

Of course, do not go off the deep end by having, for example, 50% of your portfolio in a single stock.



Additional notes:

If a stock has a 10% weighting in your portfolio, then a 20% change in price will move your overall portfolio 2%.

If a stock has only a 3% weighting, a 20% price change has only a 0.6% effect on your portfolio.

The thought processes in building a portfolio that works.

You want an investment portfolio that meets your financial objectives. 

Investors have obvious goals:  to produce wealth and to preserve capital.

You also want that portfolio to accomplish those goals quietly, with a minimum of upsets, a minimum of nerves, a minimum of complex mathematics, and most likely, a reasonable amount of effort on your part, because you are busy doing other things in life too.

The tiered portfolio is divided into three primary tiers:

1.  The Foundation portfolio
2.  The Rotational portfolio
3.  The Opportunistic portfolio.



The Foundation portfolio (80%)

This is set up to meet or slightly beat expected market returns, often with stable and somewhat defensive investments.

Dividend-paying stocks with rising dividends and growing prospects while at the same time exhibiting low downside risk and volatility are a pretty good fit.

These investments can be stocks or funds, and can be augmented by fixed-income securities, real estate, or other investments that meet this general profile.



Rotational (10%) and Opportunistic (10%) portfolio

The purpose of these is to achieve better-than-market returns, perhaps with more volatility, but these portfolios are small enough to contain risk and to avoid consuming too much of your investing time and bandwidth.



Putting together your portfolio

How your portfolio is put together is entirely up to you, not only because the portfolio needs to suit your tastes, intuitions and the facts at the time, but also because many of the investments (and the mix of investments) may not even be available, or priced right, at the time.

Building a tiered portfolio

This tiered portfolio has three segments:

1.  Foundation investments
2.  Rotational investments
3.  Opportunistic investments.


Foundation investments (80%)

These are like dividend-paying stocks that produce market (or better) returns with relatively less risk.


Rotational investments (10%)

These are mostly ETFs and inverse investments.  They add some defense and sector diversification to your portfolio.


Opportunistic investments (10%)

These employ a little more risk to boost returns.



Aim

The net result should be a portfolio that generates above-market returns with below-market risk.