A bear market is a time for lots of activity for me. A 25%+ drop in 2011, with a near collapse towards the end of the year, threw up a lot of opportunities. During such times, the problem for me is that my portfolio soon starts resembling a zoo – it has a stock of each variety.

How do I end up in such a place?

I personally ignore short term forecasts and start buying a company (usually too soon) if the valuations are attractive and the long term prospects are good. The problem with this approach is that there is no grand strategy behind it. As a result I often end up with too many stocks in my portfolio

I have gone through such a phase several times in the past (in 2005, 2008 etc) and have had to prune my portfolio after that. This time around, I made a decision to limit myself to around 22-25 stocks and any further addition would require me to sell something – keeping the total number the same.

Now, one may argue that even 20-22 stocks are too many and one should have a more focused portfolio. Let me assure you that once I gain more experience and hopefully some wisdom, I will scale back the number to 15 or less. Till then this level of diversification is an insurance against my ignorance or stupidity.

So why limit yourself?

A different way of looking at this issue is to question the need to limit oneself to any fixed number of stocks. If you can find enough good and cheap stocks, why not load up on all of them?

I have followed this approach to a small extent in the past and have realized that this results in mental laziness. Once I buy a stock, the endowment effect kicks in and then I am reluctant to change my opinion on the stock even if the company is performing below average.

In all such cases, I have finally come to senses and have sold the stock usually at a small loss. The real loss however is the opportunity cost of deploying this capital in some other high quality idea.

What is the difficulty in exiting?

It would seem very easy to exit such stocks on a purely rational basis.  You look at the original thesis of the purchase (for example – the company will grow at X %) and compare it with what has happened since your purchase. If the company is performing below expectations and will continue to do so, then you sell the stock and move the capital to a better idea.

If only life was this easy ……

The emotional part

I find the emotional part of selling a stock, which has not done well to be a painful exercise. For starters, one has to admit that one has been wrong or unlucky (usually wrong) and in hindsight should not have bought the stock.

The next problem is to find another idea to replace the one being sold, which in turn will hopefully not be dud.

The worst of both worlds is to see the old stock soar in value after the sale (yes, I have had this one too – VST industries) while the new pick stagnates.

Selling to raise the quality

There are times when if you are fully invested, the only way to invest in a new idea is to sell an existing one. I have created an artificial constraint by limiting myself to 20-25 stocks. This constraint has now forced me to rank my stocks in an order and to look for the weakest ideas in the portfolio.  How do you do the ranking? Well that’s another post, and stock price is not the only criteria.

The weakest idea now gets compared to the new idea and if the new idea is much better, then it replaces the weaker one. You can call it the survival of the fittest – each stock has to earn its position and cannot just stay put in the portfolio. There are no holy cows!!

So which of my ideas are facing the axe? Some minor ones have already been axed. I have been reviewing the Q3 results and have a few more on the chopping block now (this one is a good candidate)

Selling the mediocre ideas to buy a more attractive stock is always painful for me, but over time I have found that my overall performance has benefitted by swallowing my pride and biting the bullet.

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