information: finding a focus

Most professional portfolio managers start out as securities analysts.  That’s where they learn how to read and interpret financial statements, and how to make estimates of what the financials will look like in one or two years.  They also begin to learn how to decide whether the current stock price is higher or lower than would be justified by these projections.

In doing all this, they may work as assistants for a more experienced analyst.

In any event, they specialize in following only companies in a given industry, like retail, or a subsector of an industry, like department stores.

being a portfolio manager

This situation changes drastically if/when an analyst becomes a portfolio manager.  Suddenly, the rookie pm is looking at a benchmark index that contains hundreds of stocks in multiple sectors, each containing several industries.  Panic sets in, as he/she realizes that there’s no way to have an informed opinion on so many diverse companies.

The key to success as a portfolio investor, however, is not to have a superficial opinion about everything.  It’s to have a deep understanding of one or two things that will make a positive impact on your wealth.

my first encounter with real success

By far the most successful manager at the firm where I had my first portfolio management job worked in the office next to mine.  He had a very simple system:

at the beginning of each year he identified one or two companies that he thought would do relatively well, and one or two that he thought would do poorly.  He would build larger-than-index weightings in the former, using money he got by reducing his positions in the latter to below index weighting.

Then he’d monitor.

If the positions did what he expected, he’d let them ride until they’d made, say, +30% vs. the index (or -30% for the underweights).  Then he’d close them out (by returning the positions to neutral weighting) and repeat the process.  If the positions started moving in the wrong direction before they reached the goals he’d set, he’d close them immediately.

Usually, by May or June he’d amassed enough outperformance to achieved his maximum bonus.  When that happened, he’d make his portfolio look just like the index and essentially go on vacation until the next January.

how this applies to you and me

Essentially, my former colleague ran an index fund with most of his portfolio, with two added long positions plus two shorts, where he intended to make outperformance.

The first thing you and I should do is forget about the short positions.  They need a lot of attention, and they require a different mindset (I ran a very successful short-only portfolio early in my career.  It’s unusually risky and definitely not for everyone.)

We can replicate the “most” of  the portfolio with one or more index funds/ETFs.

My old friend had individual stocks in the “added” portion of the portfolio.  We can do that too, or we can expand the idea to include industry ETFs/funds–thereby outsourcing the stock selection function.  We might expand the idea further to permit small-cap, international or emerging markets ETFs/funds as “added” positions.  Or we might expand the number a bit.

The key, however, is to limit the “added” positions to ones we have an informed positive opinion about and which we are committed to thinking about and monitoring every day.


Tomorrow:  where to look for “added” positions.




Leave a Reply

%d bloggers like this: