Portfolio management is one of the costliest mistakes that investors make.
Imagine a portfolio as a forest, and the stocks would be trees. Investors tend to focus a lot more on the individual trees that they forget about the forest. In a diversified portfolio, one tree is not as important when compared to the forest.
A stock that has made 50% does not mean much, because the portfolio of stocks can still lose money as a whole despite the one big gain in a stock.
A good gardener would understand portfolio management easily.
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His aim is to maintain a nice looking garden. It would be a garden with blooming flowers and scent abound. To achieve that, he would have to do two main tasks; one, to rid the weeds and second, to fertilize and water the garden to keep the flowers growing.
That is exactly what an investor should do with his portfolio of stocks. Constantly ridding stocks that should not be in the holdings (weeds) and keep the ones that are still worthy (flowers).
Duh! So simple!
But often, traders and investors do the opposite – cut flowers and keep weeds.
I generally define traders to have higher frequency of entries and exits, and focus more on technical indicators or price actions to make decisions.
I define investors to make infrequent buys and sells, and the holding period tend to be longer than a trader. They also focus on business fundamentals to decide on their stock investments.
Let’s use traders to illustrate the issue first.
The mantra is to let the winners run and cut the losses short. How many traders actually do that?
It is human nature to be tempted to sell on a quick profit and keep the losses for a loooonnng time.
Think about this. If a stock goes up 10%, what kind of things are going through your head?
“Wah! 10% gain now. I think this fast gain will collapse, better take profit now.”
“This stock has been stagnant for a long time, now it is an opportunity to exit.”
“Let me take the profit first. I will buy again when it goes lower.”
These can be the stories you tell yourself. The driving force behind these thoughts is the fear of losing the profits.
Then how do traders handle losing positions? What are some of the common thought processes?
“I don’t think I should cut loss now, the last time I cut loss it had rebounded. This time should be the same.”
“I think can hold on a little longer, the central bank just released good news.”
“I will cut loss if it goes down another 5%.”
In these cases, the driving force is the fear of realising the losses.
Trading principles and rules are in place to help traders achieve positive returns. Time and again, many traders overrule such principles because of the stories they tell themselves, to excuse them conveniently as well as detrimentally.
The investors are not spared too.
Investors have a longer horizon and they can be even more impatient with the profits they are sitting on.
As an investor, you suffer from the same effect – the fear of losing profits – which propelled you to take small profits when your stock picks are right.
You are supposed to hold on to the right stock picks much longer, because you need larger gains, due to a longer holding timeframe, to get a decent return on your portfolio.
But you tend to hold on to your stock picks even though they are not worthwhile anymore as the business fundamentals may have deteriorated. Here are some possible thought processes in your head.
“The stock has already lost 90%, there isn’t any point of selling it.”
“I am a long term investor. The stock should rebound in the long run.”
“I think it will go up, I will sell when the price reaches back to the buy price.”
This is the psychological bias of loss aversion in play.
Although the handling of gains and losses are similar between traders and investors, each group have their unique challenges.
Due to the higher frequency of decision making (opening and closing positions on a daily or weekly basis), traders are more prone to decision fatigue, which results in poorer decisions and in turn yields poorer trading results. The additional risk would come from the leverage that traders take on trades, and one poor decision can result in blowing up the trading account.
Investors, on the other hand, face a challenge that traders in general do not have. Traders’ entries and exists are precise and usually price based. This is especially useful when it comes to cutting losses. For example, there is only one way to interpret when a trader is suppose to cut loss below 5% of his entry price. However, investors do not cut loss based on price. They usually have to evaluate the business fundamentals, and assess if they have deteriorated. It is hence subjective.
Putting these unique challenges aside, both traders and investors need to learn from the gardeners on the art of portfolio management – keep flowers and cut weeds. Humans do the opposite. Keeping unworthy stocks is like keeping weeds, and hoping one day the weeds will turn into flowers. It is fat hope.
If you have been wondering why your portfolio is a sea of red, it is likely you have committed this mistake over and over again.
The first step is to be aware and then to accept your mistake. Only which, you can start to change your behaviour to trade or invest profitably.
Which garden would you like to have? A portfolio of weeds or flowers?