Barton Biggs on how to stay fresh with a stale portfolio. (Article excerpt)

(Note the Flair Basics / getting started.)

Previously I mentioned about the concept of the “pre-mortem” which I read from Pat Dorsey, to ask questions on what could go wrong with an investment and then work backwards to figure out the red flags that could serve as an early trigger.

Today, I want to share this snippet from Barton Biggs, noted investor, author and market strategist. In an 1977 essay on investment strategies, he wrote that that many first year funds performed better than funds in their 2nd or third year. While motivation and size were often the explanation, he concluded that the first year phenomenon could be explained by the manager, who is in cash and looking solely at opportunities versus the manager who is fully-invested.

He goes on to suggest a method to help portfolio manager stay fresh.

I am quoting from the last three pages of his article “Investment Strategy”

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Or they may be stocks that he loves because they are "Great" companies with a capital "G" and have made him big money in the past. Investment managers, without realizing it, often personalize and become emotionally involved with stocks when the investment decision-making process should be completely intellectual and rational because, after all, they are just pieces of paper.

Or as Adam Smith put it, the stock doesn't know you own it, and there's no reward or pension paid for being a faithful long-term holder.

It is these "holds" that are too cheap to sell but not attractive enough to buy that make a portfolio stale and retard performance. An investment manager will say he has to see potential for at least a 50% gain in a year and a minimum risk-reward ratio of two to one in a stock before he will buy it, yet in his list he will hold many stocks in which he will admit the present potential is only 10%-20% and the risk-reward relationship is closer to one to one. And he won't even see the incongruity of this position.

Obviously, he can improve the portfolio's performance by selling the ten and twenty percenters and putting the money into fifty percenters.

Switching is hard (it's always easier to do nothing), and there's an inherent and natural resistance to it because the investment manager exposes himself to being wrong twice (i.e., the stock he sells goes up and the stock he buys goes down), but it's the only way to keep a portfolio young and vital. And after all, the word "manager" implies an active, involved role rather than a passive caretaker function. Furthermore, this writer would argue that rigorous, continual application of appreciation-potential analysis and risk-reward standards, while it maximizes the turnover in a portfolio, minimizes risk in that the relatively fully priced stocks are sold and relatively underpriced and attractive stocks are purchased.

Always provided, of course, that the stock selection judgments are competent.

It is significant that Bernard Baruch and Jesse Livermore, probably the two greatest private investors of the twentieth century, made it a practice completely to liquidate their holdings every so often, take a vacation, and start over by buying a completely fresh portfolio. The pattern of reinvesting from scratch is apparent from their writings, although there is no evidence that either did this as a conscious investment strategy or on a regular, predetermined basis, but yet it became almost an instinctive pattern of their operations.

Baruch relates in My Own Story how after each major investment undertaking, he would sell his stocks and "shake loose from Wall Street to go off to some quiet place where I could review what I had done." He would come back, he says, refreshed with new approaches and fresh investment ideas. Jesse Livermore, when he felt confused about the course of the market or sensed the need for a change, would "take in his lines and get into cash" and "go fishing or to Hot Springs." On his return, he would usually buy or sell short completely new stocks.

And in a way, Gerald Loeb, with his concept of "The Ever Liquid Account" where the investor automatically sells and thus gets into cash when his stocks start going down, is creating exactly the same effect. Loeb, incidentally, besides being a flourishing broker, was a canny investor with a trading orientation.

At the risk of belaboring the obvious, the point should be made again that an investment manager's performance capability is maximized by investing from a completely cash position.

However, it is impractical because of the expense and market impact to even suggest that large portfolios be totally liquidated every so often in order that the manager can have the intellectual freedom and stimulation of a totally fresh approach.

However, a manager can simulate the effects and benefits of complete liquidity. Every year or eighteen months or for that matter whenever he feels his portfolio is stale and his performance is lethargic), the investment manager must discipline himself to go off alone without any interruptions for at least a day. He must make a powerful effort to detach himself and to pretend he has sold everything, and that he has nothing but cash. Then he must invest his "cash" by constructing a new portfolio based on that day's prices, current appreciation-potential analysis, and present risk/reward ratios. He must do this honestly, and he must work through the entire process of building a new portfolio, segment by segment, including position sizes.

This exercise requires considerable discipline, and is certainly not as effective as the real thing since the mind is not truly unfettered from the old portfolio. But it works surprisingly well.

Then, to complete the treatment and get full benefit from "the first year performance phenomenon," the investment manager must modify his real portfolio to conform to the new list. Obviously, there will be considerable overlapping, but almost invariably this exercise will result in a significant reduction in the number of stocks owned. Professional money managers almost without exception are far better buyers than sellers of stock. This program is buying oriented and thus emphasizes the strength yet indirectly accomplishes the objective of selling.

This purging process is no panace for poor stock selection.

However, it can help a competent manager to work his way out of a slump, and it certainly compels the elimination of the limited potential old lumber and forces concentration of assets in the best stocks where the maximum opportunity is. It is a device, a technique, to help the investment manager focus his thinking which eventually should improve his relative performance.

Maybe successful investing is like riding a bicycle—either you keep moving or you fall down.

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