Poor Portfolio Management Sacrifices Big Bucks
By Jonathan Hoenig
  
THE HARDEST THING ABOUT having money is knowing what to do with it. Every day we are faced with decisions about how to protect and grow our wealth. New information develops, be it fundamental or technical, and we're compelled to factor it into our analysis. Portfolio management is the record of those decisions.

Every portfolio, be it an E*Trade account or multibillion-dollar pension plan, is owned by somebody, and portfolio management, first and foremost, should reflect the goals of those beneficiaries. No matter how optimistic the prospects might be, an 85-year-old retiree looking for income shouldn't have his money tied up on the Pink Sheets or OTCBB.

For most actively managed portfolios, the ultimate goal should be consistent, absolute return. Consistent, of course, because as Albert Einstein reminded us, the real money is made through compound interest over time. Absolute return, as opposed to returns relative to a benchmark like the S&P 500, is important because negative returns, even those that outperform an index, are still negative. You can't save, compound or spend a loss.

In its most obvious form, portfolio management comes down to picking stocks or other investments with the hopes they'll go up in price. You buy 100 shares of General Electric or CurrencyShares British Pound Sterling Trust with the expectation that they'll rise.

A secondary and slightly more sophisticated element is the goal of diversifying an existing portfolio. After all, it's one thing to think XYZ is a winner, it's quite another to live with it dominating your portfolio for a decade or more. Most people can't live with an account that's up 30% one year and down 30% the next. So portfolio management also involves assembling an assortment of uncorrelated strategies to dampen the volatility from a single trade. Of course, every investment should be strong in its own right before taking a position. I don't advocate buying dreck simply because it's uncorrelated to everything else in your book.

Some people take "management" to absurd levels, turning over huge blocks of their portfolios every day or so in an attempt to grab a quick score. As I've often pointed out, I think that's a loser's strategy. A better approach is to think of portfolio management as being a process of allocation rather than trading. As new information presents itself, we tweak and focus our portfolio, but don't turn them over completely.

That's why it's vital to keep close tabs on price action, specifically the price action of those assets already held in a portfolio. By keeping our eyes on the market, we are able to know in real time whether or not our portfolio is focused on the highest probability trades. For example, you need not have read about weakness in housing over the past few weeks to know the sector is in trouble. Many of those stocks have been punished for months.

For me, high probability trades are those in which, first and foremost, the market is confirming my position or belief. The proof is in the profit, as they say, and if a trade is showing green in my portfolio, that's the best indication that events are moving in my favor.

The secondary consideration comes when evaluating the position of the herd, the group of slow-moving average investors of which we're all sometimes a part. If a trade is proving successful and I can objectively determine Joe Six-Pack isn't yet involved in a meaningful way, then I'm able to remain confident the major move is likely not yet complete. I couldn't help but notice The Wall Street Journal profiled the large number of international real estate funds recently launched, an asset class we first noted back in 2002. Now that the herd is on board, the smart money should be long gone.

Most investors are comfortable only in buying bear markets and sitting out of bull ones. Is there any wonder so many lose money speculating in stocks? The savvy investor should aim to take the other side of those trades.

Finally, the trades investors should most covet are those that not only show impressive price action and lack of herd involvement, but those in which they already hold a healthy and substantial position. While I always advocate against betting the farm on any one trade, the fact of the matter is that the market doesn't know where you bought it.

If XYZ is at $30 and you bought your position at $25, plenty of people are buying it at $30 with the expectation there's another $10 to go. Those rare opportunities in which a large position has been built in a strong investment should be exploited and milked, not indiscriminately traded away.