Buying a stock is easy. Anyone can do it, with or without research. But when it comes to selling stock or managing your portfolio to achieve the best returns, the process is a bit more complicated.
Value investing legend Seth Klarman (Trades, Portfolio) shares some tips on how to manage your portfolio to produce the best long-term returns in his book "Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor."
How to manage your portfolio
The importance of portfolio management is summed up in just one of Klarman's best quotes:
“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.”
Portfolio management goes on forever. For as long as you have an investment portfolio, you need to be able to manage it. Portfolio liquidity is a key but regularly underappreciated part of this process. Klarman’s Baupost Group is well known for its large cash weighting. A high level of liquidity is extremely important, especially when investors build positions in illiquid companies.
Most investors fail to hold a significant cash balance due the pressure placed on them to be fully invested always, for fear of missing out on the wider market rally. This fear of missing out is a consequence of Wall Street’s constant pressure to encourage trading, short-termism and investors. Without cash, however, you are severely limiting your ability to take advantage of sudden market opportunities when they arise.
Cash also helps reduce portfolio risk:
“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.”
The two specific methods Klarman uses to hedge portfolio risk are the use of hedging through derivatives and diversification. How many stocks should you hold to be suitable diversified? In Klarman’s view, 10 to 15 is suitable (this is a topic that remains up for debate as most investors would benefit from additional diversification). Still, Klarman likes this concentrated approach.
“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.”
But when it comes to hedging, Klarman is cautious about using hedging instruments, which can be costly and complex to maintain:
“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.”
Although:
“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.”
Position sizing is another important part of portfolio management. Different stocks can command different percentages of your investment portfolio, depending on conviction. Klarman believes one of the best strategies to build a position, as well as an understanding of the business you are investing in, is to build a new position gradually:
“The single most crucial factor in trading is developing the appropriate reaction to price fluctuations…One half of trading involves learning how to buy. In my view, investors should usually refrain from purchasing a 'full position' (the maximum dollar commitment they intend to make) in a given security all at once…Buying a partial position leaves reserves that permit investors to 'average down,' lowering their average cost per share, if prices decline…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.”
Buying a position is just the first part of an investment; you will have to sell eventually. Klarman believes the decision of when to sell should be put in place before buying. Before entering a position, you should first calculate the intrinsic value, the point at which you are going to sell, failure to do so invalidates the entire position:
“If you haven’t bought based upon underlying value, how do you decide when to sell? If you are speculating in securities trading above underlying value, when do you take a profit or cut your losses? Do you have any guide other than 'how they are acting,' which is really no guide at all?”
And the use of stop losses is discouraged entirely:
“Some investors place stop-loss orders to sell securities at specific prices, usually marginally below their cost…Although this strategy may seem an effective way to limit downside risk, it is, in fact, crazy…a user of this technique acts as if the market knows the merits of a particular investment better than he or she does."
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