Winning by losing

It may seem counter-intuitive, but I believe one of the keys to successful long-term investing is having a fair share of ‘losers’ in your portfolio at any particular time.

By ‘losers’ I am not referring to investments that are destined to subtract from an investor’s wealth in an absolute sense over the longer term.

While we sometimes end up with such investments, I am not suggesting we actively seek to include these in portfolios. (Interestingly though, some ‘relative return’ managers are quite comfortable losing money, even over the long term, as long as they lose less than their benchmark does.)

What I actually mean by ‘losers’ is those investments that are currently performing poorly over recent short or medium-term periods (typically months or years), even during times when the overall portfolio may be doing well.

Typically, such investments could be showing a loss on the original purchase price. Usually, sentiment towards these investments is overwhelmingly negative.

In particular, this applies to fund investments (both listed and unlisted), although it can also apply to listed operating companies. (Although an operating company does not need much to go wrong to do poorly or go broke, whereas even the most poorly run managed fund will generally participate if the tide of markets is running their way.)

Why do I believe it is important to have such ‘losers’ in a portfolio?

> Having them is a good indication you are diversifying properly. In simple terms, diversifying is mainly about holding a wide range of investments that all, ideally, make money in the longer term (that is, over the suggested investment time horizon), but that individually deliver those returns quite differently in the shorter term.

Almost by definition, good diversification requires some investments to be performing poorly over short to medium periods of time.

If all your investments are doing well at the same time there is a good chance you are poorly diversified and holding investments heavily dependent on the same drivers.

> Having ‘losers’ means you are probably holding investments that are a source of good returns in the future. Investments that have done poorly in the short to medium-term are likely (although there are no guarantees) to be out of favour, contrarian plays and ultimately attractive value.

> Holding ‘losers’ can also suggest that you are ‘buying well’ because many of the best contrarian investment opportunities can be out of favour for extended periods of time and in all likelihood will go lower still after you purchase them.

Buying at the absolute bottom is a very rare feat achieved only by the very lucky.

One maxim that is often trotted out in the investment industry is ‘never average down’ when building a position.

For short-term traders and speculators, usually operating with significant leverage, this is appropriate, but for long-term investors I believe it is poor advice.

Once an investment opportunity is identified and a strong view is held that it is attractive value, it usually makes sense to buy it over a period of time. If it goes down further and nothing fundamental has changed one should simply buy more.

Of course, sometimes ‘losers’ are simply poorly managed companies in bad industries that offer little hope of good returns in the future.

Likewise, some managed funds can be poor investments because they are so poorly structured or have excessive fees versus any potential value added.

Ideally, one should seek to avoid such investments in the first place. Certainly, these are the types of ‘loser’ investments that one should consider redeeming (if it is actually possible to redeem) because they often offer little hope of resurrection, with a big ongoing opportunity cost.

In my view, many overly complicated structured products fit into this category. Clearly, discerning this difference is the art and science of good investing.

Clearly, however, outside these there are sound reasons why having so called ‘losers’ in your portfolio makes sense.

Unfortunately, much of what occurs in the investment industry goes totally contrary to this logic and approach. Instead, the industry actually seems to be good at weeding these short-term ‘losers’ out of portfolios rather than seeing them as potential sources of better diversification and future returns. I believe this is the case for the following reasons.

> Most performance tables focus most heavily on short-term performance. Poor short-term performance is all too easily extrapolated to a poor investment, and the natural inclination is to avoid or exit such investments.

> The media accentuates this trend by trumpeting the best and worst performing managers over periods as little as one month. Other vital considerations such as risk and diversification are largely ignored, and the media has a habit of compounding such coverage with naïve reporting, such as comparing performance of diversified asset portfolios against the equity index;

> Financial planners, stockbrokers and their clients seem to focus most attention on poorly performing investments at review times.

Often the easiest path is simply to throw these out of portfolios, partly to be seen to be doing something. Emotion, not rigorous analysis, is the driver for such decisions and more often than not I would suggest such decisions prove costly to investors in the longer term.

> The investment industry is constantly putting forward new investment ideas — another hot share tip, a new structured product or a new sector fund. Usually, these are investments in, or have exposure to, areas that have performed well recently. Where do investors find their source of cash for these new ideas? Typically, they sell their poorer performing or ‘loser’ investments.

Again, more often than not, I would suggest these are being sold at times they are poised to perform, and they are usually being exchanged for over-hyped and overvalued ideas.

> I don’t believe research houses are helping this situation much as they will provide (for a fee) a report justifying the purchase of virtually any investment the product manufacturers come up with, thus providing an unlimited supply of new investment ideas for those looking to switch out of their ‘loser’ investments.

Note again that I am not talking about short-term traders here. The rules for such traders are different and the maxim ‘cut losses and let profits run’ applies. However, this is not the case for longer-term investors, including the vast majority who seek investment advice.

In our experience, we see this latter pattern most frequently in listed investment companies (LIC), although it applies across the investment spectrum.

All too often, investors jump into the initial public offer (IPO) of a new LIC because it is a hot area and the area or the manager has previously done well. Initial performance typically doesn’t meet their high expectations and the fund starts to drift to a discount to net tangible assets.

Some of these investors or their advisers/brokers come across other new and exciting ideas they want to invest in. They happily sell the LIC where they may have a 10 to 20 per cent loss to fund the new investment irrespective of the fact that its return prosects are now almost certainly considerably better (with less risk) than at the time of the float.

US studies by DALBAR have shown that investors in mutual funds have done considerably worse than the overall market in the long term because they buy in and sell out at the wrong time.

Clearly, it is largely investors’ dislike of sitting through periods of losses that is costing them much money over the longer term.

Much in the investment industry today operates off ‘model portfolios’. If model portfolios are soundly constructed and followed rigorously, I believe they can help remove this emotional and costly tendency to automatically dump or avoid ‘losers’. My concern is that this is not the way model portfolios are usually used in practice.

I know from my days providing model portfolios to planners that they were usually used more as a guideline, with the planner ‘cherry picking’ the funds they liked and avoiding the ones they did not. Which investment did they tend to avoid? Almost certainly the ones that performed poorly recently, while they typically loaded up extra on those that had done well.

I have no doubt that this tendency meant they would underperform the model portfolio itself over time.

Of course, in the current environment, with most markets and particularly Australian shares doing so well, there is little talk of the benefits of ‘losers’ in a portfolio.

Indeed, some investors and advisers who have most or all of their money in Australian shares are no doubt gloating and highlighting how few ‘losers’ they actually have had.

Instead of counting their winners or considering which new winners to jump onto, perhaps they should be counting their ‘losers’ or seeking some out, as these probably give a better indication of how they will do in the future.

Clearly, sensible diversification that ultimately includes a few ‘losers’ (including other underperforming asset classes) is largely left behind in such periods.

Managing multi-asset class, multi-manager portfolios has emphasised to me the desirability of having some ‘losers’ in your portfolio at any particular time.

In reviewing the portfolio on an ongoing basis there is a level of comfort in seeing some poorly performing investments, since these tend to become the drivers of returns (and aid in reducing risk) going forward.

On the other hand, we have an inclination (although this is difficult in practice) to trim those that have done well.

We become very uncomfortable when almost everything in the portfolio is doing well. Are we insufficiently diversified? Have assets become more correlated? Have the opportunities for future returns reduced? Are all asset classes becoming overvalued?

These are important issues for portfolio construction in the current environment.

At the very time many investors believe investing has become easy because returns have been so good, we believe we are facing one of the most challenging outlooks in years. And it is partly because there are less obvious ‘losers’ in, or available to, portfolios.

Behaviourally, it is understandable why people don’t like to buy or hold ‘losers’ and prefer to only buy winners instead.

But while investors can be expected to make these sorts of mistakes themselves, advisers should know better and need to help teach their clients to respect their ‘losers’ rather than simply toss them out of portfolios with little thought.

After all, these investments are usually the key to good returns and proper diversification going forward.

That said, actually implementing this approach, particularly in the current environment, requires a high degree of conviction and is easier said than done.

Dominic McCormick is the chief investment officer of Select Asset Management .