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It’s hard to take a loss. But taking losses is necessary to avoid even larger losses.
This is prompted by Barry Ritholtz tweeting to me a piece he wrote 3 months ago called, "Take The Loss." Good piece, worth a read.

What I suggest to you today is that there is a better way to manage portfolios. Ignore the cost basis — the price at which you bought it. Instead, focus on improving the economic value of your portfolio.

It is hard, really, really hard to choose the best assets. I can’t do it. It is easier to choose assets that are better than the ones you currently own.

This assumes that you have a reasonable way of estimating the value of assets. When I was a corporate bond manager, it was easy, because I had a large number of rules to help me estimate the proper yield tradeoffs, perhaps more than most managers had at the time.

  • Discount vs Par vs Premium bonds
  • Differing maturities
  • Special covenants
  • Deal size
  • Secured, senior unsecured, junior unsecured, trust preferred, preferred stock
  • Implied credit betas of different industries (take more/less risk when you want to)
  • Spread tradeoffs needed for capital requirements and likely default/capital losses
  • Holding company vs operating subsidiary
  • Public bond vs 144A vs private placement

There are probably more, but they aren’t coming to me now. It is generally easier to estimate the tradeoffs with fixed cash flow streams with a maturity than unlimited life instruments where any cash flow back to you is uncertain.

Thus equities are squishier, where you have to compare valuation, industry trends, use of free cash flow, company quality, etc., to determine what is more valuable. This is a much harder game, but one that can be played with discipline to good effects.

It is a lot easier to do swaps in equity portfolios than to to try to create the current optimal portfolio. It is much easier to make comparative judgments (these are better) than absolute judgments (these are the best).

Other things equal, can you:
  • Improve the cheapness of your portfolio?
  • Improve the quality of your portfolio (unless you are in a period where leverage is expanding dramatically, and the opposite will pay off for a time)? This applies both to balance sheet and accounting quality in earnings.
  • Improve your industry allocations?
  • Own management teams that use cash flow more effectively, and are more shareholder oriented?

Always trade for what is better, and ignore the price where you bought the assets. It doesn’t matter what you paid; that is a historical artifact. Trade for better securities regularly, subject to transaction costs and other limits.

Source: Improve The Position