Decluttering the Portfolio

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Many thanks to Lisa Rapuano for telling me about Daruma Capital’s Mariko Gordon, and her humorously insightful letters! This article will undoubtedly be the first of many based on interesting topics extracted from Gordon’s letters. In the August 2012 letter, Gordon discusses portfolio review and its parallels to a massive home cleaning project. For those of us with hoarding tendencies, what is the impact of this psychological behavior on our portfolio management decisions? Gordon offers some wisdom:

“I have been adamant about our ‘no more than 35 stocks’ rule…Whether right or wrong, all of this pruning keeps the portfolio in the here and now, and me actively engaged in the process of evaluating whether every stock is earning its keep. And yet as with clutter, it's easier said than done… [Diversification]

If it's a big winner, it reminds you of how smart you are, and how it made your clients rich. All that warm fuzziness means that when it breaks you will crazy glue it, and never be able to let it go. That, my friends, is how you round trip stocks - the hard part is knowing the difference between an air pocket where you sit tight, and a death spiral, where you pull on the ripcord and bail. [When To Sell]

A loser in the past can likewise cause problems. Like cats, some investors prefer to bury their ‘flops’ rather than be reminded every day that they're idiots. They feel such shame that they immediately sell off a loser, unable to decouple the past enough to soberly recalculate whether the stock represents good value in the present. The fact is, if the portfolio you've been presented by your money manager doesn't include a howler or two, be very suspicious.

Too many howlers, however, may be symptomatic of another problem, this one caused by a manager who can't admit that he or she has made a mistake. These investors stubbornly insist that it's the market that's wrong (again), for disagreeing with his or her brilliant analysis. [Making Mistakes]

So let the past go…But it's not always the past that causes problems. It can also be the future.

An investor can become saddled by a position with enormous potential - potential that always lurks just over the horizon, just out of reach, despite excuse after excuse, inroads by competitors, or evidence that customers have gone on a buying strike. The future becomes a siren song of unfulfilled promise. Profits are always just another quarter away.

Whatever one's personal brand of emotional clutter - past, future, or some of both - it's all garbage. [Psychology]

No matter how elaborate the spreadsheet or how probabilistically the range of outcomes for a stock has been calculated to four decimal places, every attempt to declutter your portfolio must be accompanied by an attempt to declutter your attachment to the glorious past it represents, or the glorious future it will deliver.”