“Run your winners, cut your losers”
“Buy when others are fearful, sell when others are greedy”.
Two of the best known stock market aphorisms directly contradict each other. How can the rational investor manage a portfolio that accommodates both positions? They can’t of course which is why they, and most stock market clichés are worse than useless.
There is though a very real issue behind both phrases and that is stock selection is actually less important than stock weight for determining portfolio returns. After all, not holding a stock is simply a zero weight. Owning a stock that doubles in a year doesn’t do much for a fund if it only has half a percent invested in it. On the other hand putting 5% into a micro cap stock is a big risk and it also may create liquidity problems. Even more important than the initial exposure though are changes in weighting as stocks rise and fall relative to the index and other holdings. Investors need to know how fund managers deal with this problem to understand exactly how a fund is run.
This issue was thrown into the forefront of investors minds in the second quarter of 2010 after the Deepwater Horizon rig drilling the MC 252 well exploded and caught fire on 21st April and then subsequently sank. The scale and cost of this disaster precipitated a massive fall in the share price of BP (LON:BP.) , the operator and 65% owner of the well. At the time the disaster struck BP shares were trading at 642p. By the end of June they had dipped below 300p. Over that period BP’s weight in the FTSE 350 index fell from about 7.1% to 4.6% and created a huge change in the shape of portfolios for investors.
The way managers responded to that event gives a good indication of whether their actions added or subtracted value. Some money managers used the opportunity to buy more shares but soon found the experience increasingly painful as the stock continued to fall. Exactly who sold remains unknown but it is hard to imagine that US investors were proud of seeing that holding on their statements for the end of June going out to clients. Is it just coincidence that the nadir of the share price was reached three business days before the end of the month?
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