The Portfolio Approach

Avoiding the madness of crowds

Usually in this space I discuss specifics related to an option strategy one might use based on a view of the underlying stock, or provide an educational gem related to option pricing, strategy or mechanics. This week I want to step back and address a broader issue related to portfolio building.

Occasionally I am asked to comment on the securities held in an investors’ portfolio. To that end I will review their month-end statements and from that it is clear that few investors have any real understanding of what makes a good portfolio. Brokerage statements typically list a basket of securities centered within a specific sector with no thought about what the parts bring to the whole.

When asked why they bought or sold this or that security few have a well-thought-out reason. In fact I find that most are holding some version of the pick of the day whether it was a broker’s recommendation, a buy, sell or hold comment from analysts on television, or an interview in the financial press. In the end, the basket of stocks looks much like every other investor’s basket. The implication is that stock prices have more to do with peer pressure then with any real fundamentals.

That view is supported by an abundance of academic studies where sentiment was found to be the most influential driver of stock prices over short periods. Often referred to as momentum it is really a demonstrative example of the madness of crowds’ thesis.

Get enough investors behind a line of reasoning and irrational exuberance or apathy takes hold causing stock prices to rally of plummet beyond any price point that can be justified by the company’s financials. Ultimately saner minds prevail and prices gradually revert to the mean, leaving more than a few investors out of pocket and trying to rationalize their initial decision.

This is not a behavioral trait associated with only making decisions to buy and sell securities either. This is a trait ingrained in the way we live. A point made by a study I looked at a number of years ago authored by Matthew J. Salganik and Peter Sheridan Dodds of Columbia University, and Duncan J. Watts of the Santa Fe Institute.

The authors set about to prove the impact of peer pressure on ones’ decision process but rather than using investments, they did it with music. In this study, 14,000 participants were recruited and offered a random play list of 48 songs that they could download.

The authors sub-divided the participants into nine groups. The first group was provided the random play list and nothing else. The remaining eight, call them the “peer groups,” were provided the same random play list, but were also given information as to the number of times a particular song had been downloaded by other members in their group.

What’s interesting is that each peer group only saw the results of other members within their group. The end result was that the authors created nine independent worlds with the same play list, one world that did not know what others were doing, and eight worlds that provided knowledge of what others were doing.

The authors found that the peer groups were influenced not only by the song itself, but also by the popularity of the song among other members within their group. The study noted that the gap between the least popular songs and the most popular songs was much wider within the peer groups than was the case within the group that could not see what other members were doing.

Also interesting was the fact that the most popular and least popular songs within the eight peer groups varied. In other words, one peer group’s top ten was very different from another peer groups top ten. In short among the peer groups the gap between winners and losers remained consistent but the actual winners and losers were random. Likely because of how each group was influenced.

The results have interesting applications in the financial markets. We justify to ourselves why a stock was bought or sold, but in reality, much of what we do is random where buy or sell decisions are influenced by other investors! The downside with random decisions is that investors usually buy and sell at exactly the wrong time.

When you think about it, buying a hot stock or sector is like riding the cars of a freight train rather than driving the locomotive. The individual cars within the train can only go where the locomotive leads them!

The portfolio approach is a very different strategy. A well-constructed portfolio is akin to a well-oiled orchestra in that both are based on the concept that the whole is worth more than the parts. With a portfolio decisions to add a new investment must always be assessed within the context of what it brings to the whole in terms of return enhancement and risk mitigation. That basis of optimum diversification in that a well-thought out collection of securities may not dispense the best return over short periods, but longer term, produces solid risk adjusted returns.

The longer term argument is the foundation of the portfolio approach because risk mitigation takes fear out of the equation allowing investors to hold long enough to let the portfolio deliver on its long term trajectory.

As a final thought I am not suggesting that you should never engage in strategies that we talk about in this blog or that might appeal to you based on analysis done by others. But those investments should be made with risk capital and should never be part of your core holdings. Have fun with specific ideas and suggestions but recognize that potential gains or losses should not influence your long-term investment objectives.