I wrote earlier about a Darwinian approach to portfolio construction. This approach involves the ranking all the stocks in a descending order and replacing the last position with a better stock/ idea. The key concept behind this idea is to replace the weakest position with a stronger one and thus improve the portfolio quality.

A 2X in 3 years
As the title suggests, I have now started asking a question for each position (at the time of quarterly and annual results) – Does this position have the potential to double in 3 years ?

How does one look at the potential ? There are two variable driving the stock price – earnings growth and valuation. Lets say the stock is selling at intrinsic value and the earnings are growing at around 24% per annum. At the risk of over simplifying (and not stating some additional factors), we can expect the stock to increase at roughly the same rate and thus double in 2 years.

Not a scientific exercise
One can easily find a lot of flaws in the above thought process. You can argue that, no one knows the market situation three years from now. In addition, the company performance may turn out to be much lower than expected, thus negating the entire exercise.

What do to with such cases
Lets say you identify a stock where the potential return is unlikely to be 2X in 3 years. What now ? do you sell and buy another stock ? What if you don’t have another idea ?

I don’t think so. I would say the opportunity cost is the average returns you have made over the long term. Lets assume that your portfolio has returned  15% per annum on average in the last 10 years. I would say that this is your opportunity cost and the existing position has to be above this threshold to remain in the portfolio

So the question to ask is – does this position meet my opportunity cost threshold? If yes, hold on to it till you can find a better idea – preferably a 2X or 3X in the next few years.
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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

I ran a few ‘experiments’ during the year, some of which I wrote about on the blog. As the year draws to a close, I am preparing the report card and as always it’s a mixed one – Lots of D and F and not a single A J

Let’s look at some of these experiments, learnings and plans for next year.

Buying dirt cheap stocks
The main ‘idea’ behind these positions was that the stock was dirt cheap and hence once the pessimism cleared, the price would bounce back

Business cycle related
The capital goods sector has been hit very hard in the last few years and the news worsened during the year. As I wrote in this post – ‘How I think about macro’, I personally thought the pessimism around this sector was overdone and one could look for some quality firms in the industry to take a position at rock bottom valuations.

You can see the price action below

So what’s the grade ? It’s a B at best for the following reasons

Learnings
– I don’t have timing skills and this episode proved it again. I care about buying at the right price rather than at the right time. However in the above example, it is important to get the timing right too, otherwise one will have to wait for a long time. A number of fellow investors I know are experts at this – but I am not. As a result, this type of investing has rarely worked for me.
– Due to the lack of timing skills (and being aware of it), I have been hesitant to create a large position in such opportunities. The result of a small position is that a 33% return, does not move the needle on the portfolio. As a result, buying such kind of stocks, which I do not plan to hold for the long term are just a waste of time (for me)
– These kinds of timing opportunities in the end may just be good to keep me entertained, but will not add to my returns in the long run.

I wrote about zylog here. I  laid out the argument for this position in the post and the reason for the eventual exit.

It is easy to look at this episode with hindsight bias (management was suspect and hence one should not touch the stock).  Around the same time last year, I was looking at some high profile cases of failure (read here) and wanted to test the following hypothesis – is it possible to figure out management fraud from publicly available documents such as annual reports (market grapevine does not count).

The above trade turned out to be a disaster as it soon became known that the management was indulging in insider trading.

Value trade
I wrote about this short term opportunity here. As I noted in the post, this is a stock which had become cheap for  short term reasons (quarterly earnings miss), though there was no long term issue or any management concerns.

This type of investing is more suited to my personal temperament. I am able to analyze that the market is being too pessimistic due to short term factors. If the business is doing fine and there are no management issues, I am able to take a mid size position and make reasonable returns over a one year time frame.

Not all trading
If you have started reading my blog recently, you may feel that I am into short term trading. That is miles from the actual reality. The above cases, are just experiments on the side, representing not more than 1% of my personal portfolio.

The long term changes
The key change I have been focusing on my core portfolio, is moving towards higher focus or concentration. I have kept a fairly diversified portfolio in the past with majority of positions under 10% of the total portfolio. I have now started increasing the size of some positions where I have a higher level of confidence in them.

Chicken that I am, the move is likely to be very slow and measured.

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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

I think behavorial finance is a very important topic for an investor (and in other walks of life too) and one should spend some time learning about and trying to avoid the common psychological pitfalls. I discussed some of these pitfalls in the previous posts (hereand here).

Poor charlie’s almanac
Thinking fast and slow
The psychology of influence
The art of thinking clearly
Seeing what others don’t : The remarkable ways we gain insight

Lets explore a few more baises and how one can avoid them

Sunk cost fallacy
This is a tendency of investors to throw good money after bad. Once you make an investment in a stock and the price starts to drop, the general tendency is to average down. If one analyses the company based on current facts and arrive at an objective conclusion that the price drop is unwarranted,  then buying/ averaging down is a good approach. However most investors (including me) remain anchored to the previous conclusions and are also influenced by the sunk cost – money already invested in the stock. As a result, majority of the investors refuse to change their mind and incur heavier losses in the future.

I have been guilty of this fallacy a lot of times and find it difficult to change my mind quickly. At present, the best antidote I have is to acknowledge my weakness, look for disconfirming evidence and act on it, inspite of looking like a fool at that time.

Story bias
Humans are suckers for stories. We understand the world in the form of stories. Our epics and mythology are stories and so are films and other forms of entertainment.

How does one avoid getting sucked in? There is one word for it – valuations. Never overpay for stocks, no matter what the story. If something is obvious to everyone, then the price reflects it and it is ‘overconfidence and hubris’ on part of most investors to assume that they are smarter than the market.

Almost everyone tends to neglect the base rate – statistical probability of an event. Investors tend to do the same. Let’s consider some examples – 90% + options expire worthless and various studies have shown that IPOs tend to underperform market over the long run. Inspite of these statistics, investors believe they can do better, mostly because they are not even aware of the low success rates.

In summary, know where you have an advantage and work on exploiting it. For example – I know for a fact that I cannot beat a full time trader in the short term and hence I will never invest in a stock or option where the odds are stacked against me.

One needs a level of optimism or confidence to do well in life. At the same time, there is fine line between confidence and over confidence. How do you know you have crossed it?

What about me? I have had the reverse problem – I have always been underconfident and that has been harmful too. I have underallocated to equities in the past and created smaller positions in my top ideas. As a result, my opportunity loss has been far higher than my actual losses.

No silver bullets
We have reviewed several biases in a series of posts. As you can see, it is easy to understand these biases and even recognize them in yourself. It is however far more difficult to overcome them – I am often aware that I am irrationally committed to an old idea, but still struggle to exit/ sell the stock.

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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.