When managing an investment portfolio, it is necessary to answer six straightforward questions. The questions are what to buy, when to buy, how much to buy, what to sell, when to sell, and how much to sell. All one needs to do is to have an adequate plan for answering these questions and the job is complete. When the task of investment management is framed in this manner, some of the drawbacks of the more common approaches are exposed. For example, if you read the financial press or check out the personal finance section of your local bookstore you will find a disproportionate amount of attention focuses on the first question, what to buy, and not nearly as much on any of the others. What to buy is important, but it is not really the most important driver of investment performance. The next two questions actually have more of an impact on overall performance. The “how much” questions are much more significant than the others, but get relatively little attention. Frequently, the answer to “how much” is the amount of “spare” cash lying around in an account. This is a rather shortsighted way to manage a portfolio and can result in being poorly positioned when market trends change and can also lead to over- or under- allocations to important asset classes. Investors who have not given ample consideration and attention to the “how much” question frequently are exposed to unnecessary amounts of risk due to their misallocated portfolios.
|What to buy?||What to sell?|
|When to buy?||When to sell?|
|How much to buy?||How much to sell?|
The “when” questions are similarly not well planned. “When” is usually now. Personal finance magazines tout, “Seven funds to buy today!” They never print articles with titles such as, “Seven funds to buy sometime over the next six months, but only if prices decline at least 5%.” I can say with absolute conviction that two years ago was a much better time to be buying stocks than today. When you buy is of critical importance. Buying Cisco or Microsoft in the 1990s was a great investment. Buying them in the 2000s was a poor investment. Selling almost any stock was a good idea in early 2008. Selling almost any stock a year later was a poor idea.
The selling versions of these questions get far less attention than the buying versions. This reflects our everyday experiences. We have a wealth of experience buying stuff, like food, clothing, transportation, shelter, etc. Comparatively speaking, we have no experience selling anything. Most of what we consume, we never sell. We might sell a few things over our lifetimes, like a house or an automobile, but the number of buying experiences dwarf the number of selling experiences. So we are much more comfortable buying and understand how to conduct that process. Since we have so little experience selling stuff, we typically resort to relying on our gut feelings about what feels right or how others handle the task. But relying on feelings or the opinions of the majority will likely get us into trouble when making financial decisions. We can eliminate the feelings of dread by selling stocks at a market bottom, and we will have plenty of company. However, such decisions are extremely costly. Correspondingly, we can refuse to sell after sizable rallies, because “everyone” knows that prices of the most favored asset class will never go down. Ask anyone who owns gold today about selling, and they will question your wisdom, since gold has not experienced a sizable price decline in many years.
So how does one go about deriving well-thought out answers to the six questions? Lurking in the background is a seventh question: why? An effective process for deciding what, when, and how much to buy and sell needs to be based on a firm understanding of how financial markets work, the nature of risk, the psychology of investors both individually and in aggregate, and the mechanics of portfolio design and maintenance in an ever-changing landscape. The process I use reflects what I have learned from studying the successes and failures of other investors as well as my own. It is fully described in my book, Cognitive Investing: The Key to Making Better Investment Decisions. It answers the all-important question of why, and once you understand the why, answers to the other six questions are no longer so puzzling.