Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Howard Marks on knowing when to hold ’em
Despite the popularity of that old adage, it’s never as simple as “buy low, sell high”. But if it’s not true, what are investors to do?
“Everyone is familiar with the old saw that’s supposed to capture investing’s basic proposition: “buy low, sell high”,” writes Oaktree Capital founder Howard Marks in his latest memo, ‘Selling Out’. “It’s a hackneyed caricature of the way most people view investing. But few things that are important can be distilled into just four words; thus, “buy low, sell high” is nothing but a starting point for discussion of a very complex process.”
The temptation to sell is highest when the price is rising – when there are some gains to be realised, and before some PR disaster drags the price back to earth. But, as Marks says, it’s not that simple.
He uses the example of Amazon. Everybody wishes they’d bought it for US$5 at its debut, but few would have had the discipline to not sell it when the price increased to US$85 over the next few years. Likewise when it fell 93 per cent – back to US$6 – in the Tech Wreck. And how many could have resisted the urge to sell it at $600 in 2015? Doing so would have deprived them of a stock now worth more than US$3000.
“In short, a good deal of selling takes place because people like the fact that their assets show gains, and they’re afraid the profits will go away,” Marks writes. “Most people invest a lot of time and effort trying to avoid unpleasant feelings like regret and embarrassment. What could cause an investor more self-recrimination than watching a big gain evaporate?”
“And what about the professional investor who reports a big winner to clients one quarter and then has to explain why the holding is at or below cost the next? It’s only human to want to realize profits to avoid these outcomes.”
But at the same time, selling just because the price is down – or because you think it will be – is also the wrong course of action. Marks cites studies that found that on average, mutual fund investors tend to do worse than mutual funds themselves; they “sell the funds with the worst recent performance (missing out on their potential recoveries) in order to chase the funds that have done the best (and thus likely participate in their return to earth).”
But the “ultimate proof” for why you shouldn’t necessarily sell something when it’s down comes in the form of distressed debt.
“The essential ingredient in Oaktree’s investments in distressed debt – bargain purchases – has emanated from the great opportunities sellers gave us,” Marks writes. “Negativity reaches a crescendo during economic and market crises, causing many investors to become depressed or fearful and sell in panic. Results like those we target in distressed debt can only be achieved when holders sell to us at irrationally low prices.”
“Superior investing consists largely of taking advantage of mistakes made by others. Clearly, selling things because they’re down a mistake that can give the buyers great opportunities.”
The question of when to sell has a simple answer: (almost) never sell. Just being invested – and taking advantage of compounding returns- is “by far the most important thing”, while attempting to take advantage of short-term price movements by hopping in and out of assets will inevitably lead to losses.
“Investors often engage in selling because they believe a decline is imminent and they have the ability to avoid it. The truth, however, is that buying or holding – even at elevated prices – and experiencing a decline is in itself far from fatal,” Marks says. “Usually, every market high is followed by a higher one and, after all, only the long-term return matters. “
“Reducing market exposure through ill-conceived selling – and thus failing to participate fully in the markets’ positive long-term trend – is a cardinal sin in investing. That’s even more true of selling without reason things that have fallen, turning negative fluctuations into permanent losses and missing out on the miracle of long-term compounding.”
Which all sounds like an excellent way to wind up paralysed by indecision. But to Marks’ mind, there are still plenty of good reasons to sell – but those reasons have little to do with the movements of markets.
“(Sidney) Cottle’s concept of “relative selection” (that most portfolio decisions are relative choices) highlights the fact that every sale results in proceeds,” Marks writes. “What will you do with them? Do you have something in mind that you think might produce a superior return? What might you miss by switching to the new investment? And what will you give up if you continue to hold the asset in your portfolio rather than making the change?”
“So it’s generally not a good idea to sell for purposes of market timing. There are very few occasions to do so profitably and very few people who possess the skill needed to take advantage of these opportunities.”
