Sunday, December 20, 2015

The tail can wag the dog too

Investors believe that it is their top holdings that matter the most. The top picks are expected to make all the difference to an investment portfolio. So, all energies get spent focussing on the top bets. Investors guard them possessively spending disproportionate time on detail and debate related to their top holdings. But, if one's largest holding is a HDFC bank or Coca Cola company, there isn't much to do really. One just needs to sit patiently and watch time pass by. Inactivity is what will make all the difference to outcomes. Yet, the moment an investor finds a new idea that excites him, he starts looking for capital to buy it. A natural outcome is that investors tend to sell his performing stocks. He simply lets go of a good bet just because it has done him good and he wants to move on. Often, as market cycles mature, investors sell marquee stocks which form the core of its portfolio to buy untested newbies. A classic example is the selling of FMCG blue-chips in 1999-2000 to buy untested IT and dot com newbies. A more recent example is the selling of FMCG blue-chips in 2008 to buy frothy infra and power stocks. Notice that in both instances, FMCG stocks were sold. Investors tire very easily of holding stocks that are predictable and unexciting. They tend to easily let go of them only to buy exciting stocks which carry high risk. lower long-term predictability and provide activity. Often, the excitement of doing newer things is the cause for investment decisions being taken sidestepping even the real merit of selling. Investors easily succumb to the fallacy that a richly valued stock can easily be bought back as it could be in the middle of a time correction. So, selling your core stocks when they are richly valued just so you could experiment with newer ideas is simply not the done thing. Remember, Buffett hasn't traded GEICO, WELLS FARGO or COKE every time they looked richly valued. Nor, has he considered selling them to buy newer ideas. The portfolio's core must be protected and its character kept consistent over time. Changes to the core must mandate very high conviction. 


But, an investor can't remain idle. He needs to find activity. So how can an investor do incrementally productive things, innovate and experiment with new ideas? How can he do it without messing up his existing investments? How does his search for ideas co-exist with the need to keep his strategy stable , contiguous and consistent? The continuing research and search for new ideas should be done in a way they don't invade existing portfolios. So, new research must be given their own space. 

The portfolio's tail is that place one should assign for newer ideas. Turning the tail into a portfolio driver is an interesting way of making portfolios breathe fresh ideas, creating newer drivers for returns and yet not upsetting the applecart too much. 


My prescription is simple. Separate your portfolio into two parts. The first part is your core portfolio that must have a limited number of stocks. The core will usually contain long-held stocks one intends to hold even longer. The second part , which i call the tail, is a  satellite portfolio that acts as your investment lab. In your satellite portfolio,  you experiment with newer ideas, buy stocks where your conviction is still evolving and carry stocks where your conviction is growing with the idea. A stock usually spends time in a satellite portfolio before it qualifies to become a part of your core portfolio. This phase is akin to a "Cooling period" or "Silent period" when you asks yourself a lot more questions. The cooling period helps you understand the counter arguments, answer them or decide they aren't serious enough to change your conviction. As conviction grows, you add to your existing positions in the stock. Gradually, you scale up your exposure to the stock and raise its portfolio weightage. Importantly, this scale up is strictly a function of rising conviction. Capital appreciation will also play its part in raising a stocks weightage and taking it up in your allocation. A stock earns its position in a portfolio. I am a firm believer in that principle. If we identify a stock's merit correctly, we must reward the stock with a higher position in our portfolio and the stock subsequently lives up to its promise. Then, the stock will gradually rise from the tail to the core of a portfolio. 

My top holdings of today were the tail stocks of my portfolio a decade ago. I held them long years to build conviction. As my conviction grew and became stoic and unshakeable, I helped myself to own more shares of them. My hunger to own more shares grew naturally. It is important that that a stock gets more attention only when this happens naturally. Over a decade, what was the tail of my portfolio became the driver and enjoys the bulk of the credit for my investment performance. 


My portfolio has a long tail. The bottom 30% is my investment lab. That is where i experiment and give room for my investment hypotheses to be validated. Some of these ideas move very fast in very short bursts of time earning their place in the portfolio's core. The others spend more time forcing me to fine-tune my understanding and question my own investment theses more critically.  The tail of an investment portfolio is no more a doghouse. One can ill afford to think " Oh but I don't really own much of it. So why bother?"  If one own's very little of a stock, the question to ask is " Why is this not good enough to grow as a position?". If one manages the tail of a portfolio well, it could well make all the difference your portfolio needs. 

The tail can wag the dog too. 

8 comments:

Khambatta said...

Good way to look at it.

One question:
Why would you not prefer to wait until you have much higher conviction to invest larger amounts, rather than invest small amounts in items where the conviction is not yet high?

joseph P joseph said...

Just before reading your blog,I was thinking of a portfolio, which allows me to trade too, so as to be active ever ! Playing/trading with high conviction stocks may benefit well, till it is transferred to the ever holding list, naturally/trapped seems to be good idea for me too !! Because even trapped stocks give us good returns in long. Thank you shyam..

Aditya said...

Thanks for nice article....

Aditya said...

Thanks for nice article....

Aditya said...

Nice

Aditya said...

Nice

rathna prithvirajan said...

A good idea to have core & satellite portfilio for non-proffessional investors who have Ltd resources. Col RP Rajan, Retd.

rathna prithvirajan said...

A good idea to have core & satellite portfilio for non-proffessional investors who have Ltd resources. Col RP Rajan, Retd.