I had been thinking of how to structure an investment policy that:
1. When the market provides opportunities for excess returns, accepts it gracefully without artificially stifling it.
2. When the market takes a dangerous dive, the returns are given back grudgingly.
This much is covered in traditional finance and portfolio management books.
But I am also equally interested in developing a portfolio policy that:
3. When lady luck smiles big time, gives enough scope for her to do magic.
4. When lady luck frowns big time, survives and does not cave in.
If lady luck sounds too mushy or non-scientific, you can replace luck with “non-market related statistically unusual period of positive portfolio performance” and likewise bad luck with “non-market related statistically unusual period of negative portfolio performance” (And yeah. I just made up these terms .
There is a subtle but important distinction that I would like to make between the market behaviour and behaviour of lady luck. Both produce similar results but have different cause. I will give examples to clarify my point of view.
Market provides opportunities for excess returns:
The pricing of a stock just doesn’t make sense. You are able to identify what seems like a sure shot multi bagger.
Stocks that you like and wanted to buy for a long term are available on sale ( 52 wk low, 2/3 years low).
You are very clearly able to identify a deep value stock.
Market takes a dangerous dive:
I don’t think much explanation is needed. I am refering to market behaviour seen pretty much throughout last year … free fall.
Lady luck smiles big:
There is a clear difference between finding value stocks and presence of luck. I DON’T consider finding a deep value stock or a potential multibagger a matter of luck. I repeat. Finding value stocks is NOT luck. It is just a matter of patience and keeping the eyes open.
So, what exactly do I mean by luck?
You identify and buy a value stock and it jumps by 50% within two weeks. Now this is luck.
You identify and buy a deep value stock and it dutifully doubles in a very short time. Luck at play again.
You shortlist three stocks as value and select one of them for buying and that is the one that shoots up fast. Lucky you.
You buy stock A. It shoots up. You sell A and buy stock B. A falls and B shoots up. Luck at work again.
You buy a value stock. You reasonably expect it to be a two bagger. For some reason you don’t sell and it turns out be a 5 bagger.
You are on a roll and could do just about nothing wrong.
Lady luck frowns big time:
You identify and buy a value stock. You wait for a long time to be proven correct. The stock simply refuses to move up. You decide to throw in the towel and sell. The stock shoots up by 100% shortly thereafter.
You have to choose two out of three value stocks – all identified after painstaking research. You choose (very intelligently) two stocks and they both fall immediately. The third one, that you did not buy, shoots up.
You like stocks A, B and C. You buy stock A. It falls. After some time, you can’t take the pain anymore. You sell A and buy stock B. A goes up and B goes down. After some time you sell B and buy stock C. Now B goes up and C goes down. Uggggh!!!!!
And now this is the very best form of lady luck frowning big time and almost out to get you: You found a stock that is compelling value. Absolutely compelling. You sell some other stock to buy this one. This stock goes down – way down. You sell other stocks further and bet big on this one. It keeps falling down and you repeat the process. This stock is now your single biggest holding. And then:
It turns out that the company indulged in massive fraud (Think Satyam).
Or that it is facing massive unanticipated losses (Think IT companies with hedging losses).
Or that the fall is due to market re-rating – something that is unlikely to change in the near future (Real Estate companies).
Or the company is involved in a some kind of scandal (Pyramid Saimira).
and the stock nosedives. Sound familiar?
I am not too concerned about making the portfolio bullet proof against sharp decline of the market or against worse than average luck – Graham has already spoken about asset allocation. My thoughts on it can be found here. What I am most concerned about is how to include market opportunities for excess returns and scope for luck in the portfolio policy. Please notice the terminology here – it is SCOPE. It is not anticipating or expecting or depending on luck. You acknowledge that on average you expect average luck.
What kind of portfolio policy shuts the door on lady luck even when she is desperately trying to reach out to you? What kind of portfolio policy precludes the possibility of taking advantage of excessive returns?
A portfolio policy like this:
1. Always sell a stock at 50% profit.
2. Always have an allocation of 50-50 in stocks and bonds/cash.
When you sell every stock at a profit of 50%, you are killing every scope and possibility of sheer luck landing you a multibagger (not to talk about your own efforts at finding multibaggers).
If the asset allocation policy doesn’t allow for excess allocation in equities when it makes sense, it effectively introduces a drag and decreases portfolio performance.
If you put a small capital in a deep value stock, you are effectively reducing the returns from a good idea.
What is the solution?
I have given quite some thought to this issue and came up with two solutions that seemed satisfactory (to me, if I may add). Both solutions involve having two portfolios. One portfolio where you play “to survive” and “not to lose” and the other one where you “play to win”. Both involve having a core rock solid Graham portfolio.
In the first solution, you take the cash profits generated from this portfolio and transfer it another portfolio which is meant concentrated deep value investments. These investment opportunities don’t come by everyday. As and when they occur you bet big (concentrate) on such opportunities. You can focus on the multibaggers in this portfolio.
Now there is scope for this portfolio to grow real big real fast.
In the second solution, you still operate from a core Graham portfolio. At 50% profit instead of selling completely you sell two thirds of stock (ie. take your capital out) and transfer one third stock into another “profit portfolio”. Some of the stocks in the profit portfolio are going to turn out to be multi-bagger. Managing the profit portfolio is quite simple. You keep on holding stocks without selling them unless you find a compelling value based replacement or if the market is dangerously high (say Nifty P/E > 25).
In both cases you periodically rebalance the Graham Portfolio and the other Portfolio.