Sell Discipline

diversification, risk, and SELL Discipline

Diversification

How do I think about diversification? Let’s start with an unrealistic hypothetical situation. I have hundreds of investment alternatives but I know with certainty that 1 will be the best. I’d be stupid to invest in anything but, I would put every penny in that investment. However we do not live in that world which leads us to the concept of diversification. Diversification is often explained to investors that we do not know which asset classes will outperform so we should own a little bit of everything. I do not know which equity market will outperform, or which bond market will outperform, or which particular investment style will outperform. But to me the concept of diversification is different for similar reasons. If I have 10 stocks that all go up 20%, I'm no worse off if I bought all 10 instead of just 1, but if some stocks go up 20% and some do not, I'm better off than if I had picked the worst one - that's diversification. If I invest in some of them and invest in other investments that I perceive to be safer with lower potential return, I call that dilution. That does not mean I will not invest in things I perceive to be safer, it means those will have a different investment objective so understanding your different investment objectives is important.

What is Risk?

People often ask, “what is risk?”. The industry defines risk as short term volatility as measured by standard deviation. I do not (short term volatility can also create opportunity). There are numerous risks when it comes to investing but let me start with a comparison. When you’re in a car, what are your risks? Getting killed in an accident? Getting injured? Getting a flat tire? Losing traction due to worn tires? Mechanical failure? Getting a speeding ticket? Picking up a serial killer hitch hiker? The point is there are numerous perspectives of risk. My investment risks are the permanent impairment of capital or the inability to achieve long-term investment goals. Short term volatility is not a risk to me unless it results in the market being irrational longer than I can stay solvent. The lack of liquidity can be a risk, or poor investment decision making. Overconfidence, or as I like to otherwise describe it as “believing you know everything without leaving room to be wrong” can be a risk. Paying too much can be a risk which can either result in an impairment of your capital or that it takes an inordinate amount of time to get your money back. The big risk in 2000 was overvaluation and if you held on, it could have taken 15 years just to get your money back, 15 years of 0% return does significant damage to meeting your investment objectives. The risk in the panic of 2008 was not necessarily overvaluation, the biggest risk was joining the panic and selling at the bottom and missing the recovery. Another risk would have been being over-invested in U.S financials that suffered significant impairments that were very damaging to equity investors. Someone might challenge the notion 2008 was not a valuation problem and my simple response is this: From December 31, 2007 to December 31, 2016, the S&P 500 in $US returned 7% per year, not amazing for 9 years but not bad considering that includes a financial panic. Buying along the way down would have improved that investment return.

Sometimes risk management can be akin to crossing a river by jumping from rock to rock (which may be a rock-solid landing or more slippery than expected) and other times it’s in the ocean jumping from boat to boat (which may be seaworthy or not).

Investment managers often get asked about their sell discipline and it’s a difficult concept to adequately put into writing because it’s not set in stone. Ultimately my sell discipline would depend on deteriorating fundamentals, managing a weight, or reducing a position because of valuation. If fundamentals are deteriorating and the valuation and future expectations are not baked into the stock, there could be a case for reducing or exiting completely. If a good stock keeps going up and its weight gets too heavy, then reducing is likely in order. I will likely look to trim after an increase of approximately 20-30% but there may be valid reasons to hold off. If a stock’s valuation is getting too high for its fundamentals then a trim or exit might also be warranted.

Another way to look at sell discipline is being willing to trim or sell holdings that might have upside potential in favour of names that might have more upside potential. Of course investors must account for the different risk profiles but all else equal, more upside for similar risk is sometimes more attractive.