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Portfolio Rule Eight

Make changes to the portfolio 3-4 times per year. Evaluate the replacement candidates as a group against the current portfolio. New additions must be better than the median idea currently in the portfolio. Companies leaving the portfolio must be below the median idea currently in the portfolio.

Many investors are undisciplined when they make decisions to add stocks to their portfolios.  They see what they think is a neat idea, and they add it to their portfolios.

Don’t think that it is that much better in institutional investing.  Often Chief Investment Officers, and portfolio managers react to news cycle, and demand action from their analysts when the analysts are behind the curve.  That is not a time to ask for action.  Once an event has happened, it’s too late.  Ignore it, and move on.

You might say to me, “But wait!  There is new information here the changes our opinion about everything!  We have to make portfolio changes here!”  Okay, take a deep breath and ask yourself the following question, “At current prices, which have reacted to the change in the news, what advantages do you have relative to all of your competitors who have all seen the same news?”

Most the time, after an event has taken place, there is little advantage to investing in securities that are affected by the event.  The objective of an investor is to get ahead of the curve.  Far better to ask, “What is not being noticed by the market here?”  That’s what I do when I do my industry studies.  I try to get away from the short term news flow, and ask “Where will things be three years from now?”

Yeah, that’s tough to do.  But why play games where we chase our tail by trying to gain an advantage off of current news flow?  That is a loser’s game.

That is why I deliberately try to slow things down when I am making changes to the portfolio.  I take action in changing the portfolio 3 to 4 times a year and when I make changes, I tend to trade three or four stocks.  An approach like this gives me roughly a 30% per year turnover rate.

Ganging up decisions like this forces decisions to be more dispassionate, and not subject to news flow.  It forces me to look at valuation metrics, momentum, industry factors, and sentiment factors.  By the time I am done, I will have identified a group of companies in my current portfolio that are not as good for future performance as a group of new companies that I have identified.

Where do those new companies come from?  Often they come from my industry studies.  I will go through those industries and look for attractive names.  I will then add them to the list of candidates.  Sometimes they come from my reading.  I will read an article and say, “That’s a good company.  Add it to the list.”  At other times I’ve seen article that runs a screen that I think is interesting; I will add those names to the list also.  And, if I’m really scraping the bottom of the barrel, I will run a variation of Ben Graham’s screen that combines price-to-earnings and price-to-book, and add in the names that look interesting.

When I do the grand comparison, I take all the names that are in the portfolio already and compare them against the replacement candidates.  I rank them on a wide variety of valuation factors, some sentiment factors, and momentum.  Before I start the process, I look at all the factors and ask how important they are in the current environment.  What is scarce?  What is common?  I give more weight to what is scarce and less weight to what is common.  If there is significant momentum in any factor, I ask how long momentum has been there, and whether it is getting tired, or showing signs of blowing off.  Most of the time, if there is momentum in a factor, I will give it more weight.  But if it is getting long in the tooth, I will drop the weight of that factor.  If the momentum is crazy, I will drop the weight of that factor.  Normal momentum is a positive.  Failing or crazy momentum is negative.

Once I have my factor ranks, and I have weights for my factors, I can then calculate grand ranks.  Then I sort the entire portfolio and replacement candidates on the grand ranks, and I look for the median stock currently in my portfolio.  I look below that stock for companies in my portfolio to trade away.  I look above that stock for candidates to add to my portfolio.

Now comes the hard part.  I look at the financials of each of the replacement candidates.  In most cases I end up finding that there is something wrong with the company and that is why it is so cheap.  But usually I find three or four names that are cheap for no good reason.  I buy them, and sell away companies that are relatively rich in my portfolio.

That does not guarantee that I have best portfolio in the world, but it does mean that I have a better portfolio, most likely, than I had before.  And, if you can to improve your portfolio quarter after quarter, your portfolio will deliver good results.

And so far, that is what my portfolio rules have done for me.  I’m done with the eight rules, but I will close this series of posts on how the eight rules work together.

PS – I always wanted to complete a series when I was writing for, where I would explain all of my eight rules.  Now I have done so.  And, you have gotten it for free.  Such a deal.

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2 Responses to Portfolio Rule Eight

  1. [...] Why it makes sense to make portfolio decisions in batches.  (Aleph Blog) [...]

  2. [...] Portfolio Rules New ideas have to be better than your median position [...]


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.

Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.

Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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