Saturday, May 21, 2011

Discipline: The Difference Between Amateur Investing & Professional Portfolio Management

I was recently reminded of a key difference between amateur investors and professional portfolio managers.

Several months ago, a former business partner who had failed to perform according to his obligations, obtained equity selection information for last November. Being information, I could not unsend it, and, with his continued failure to perform, I wasn't going to manage his equity investments for free.

As it happened, he had asked me to accept trading authorization for an equity account, which placed me on the firm's list for duplicate confirms and statements. Thus, I was able to observe his attempts at using the November information.

Despite his having been familiar with my portfolio management approach and discipline for over four years, as an amateur, he stumbled badly in his attempt to emulate my management of his portfolio.

First, he dithered for nearly four months before deciding to buy the equities which my process selected in November. Since each portfolio has a six-month duration, this was a significant mistake on his part. But he compounded that error by investing in some, but not all of the equities in the portfolio.

As I reviewed his holdings at the end of April, when the November portfolio would be traded to conform to May's selections, I noted that his account's performance was roughly 10%, or less than half of my November's portfolio's full term gross performance.

Significantly, one of the equities he failed to buy had the second-highest total return in the portfolio. Omitting that equity not only denied its excellent return, but, due to weighting effects, caused him to buy more of the lower-return equities in the portfolio. Only two of the other issues underperformed the S&P, and not by much, whereas the rest of the portfolio widely-outperformed the index since November, resulting in a gross total return nearly twice that of the S&P500 for the period.

I have taken heed of James O'Shaughnessy's advice to quantitatively-oriented portfolio investors that they should adhere to their model, not second-guess it. My former partner and I had discussed this important point often. Thus, I thought he understood the importance of disciplined investing.

But, in the final analysis, his amateur nature was displayed by his inability to practice the discipline of investing according to an approach which he knew would, when followed faithfully, significantly outperform the S&P.

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