Seth Klarman on Portfolio Management and Trading

This is a series of posts exploring the investment philosophy of Seth Klarman, as detailed in his book Margin of Safety.

Portfolio Management and Trading

Portfolio management involves trading activity, regular review of one’s holdings, maintaining appropriate diversification, hedging when beneficial, and managing portfolio cash flows and liquidity. What follows are insights on each.

Liquidity

Although liquidity usually isn’t of great importance for a long-term oriented portfolio, the opportunity cost of illiquidity can be high so the value investor should strive for an appropriate balance between liquid and illiquid assets.

Diversification

The number of securities that will effectively reduce portfolio risk through diversification can be as few as 10-15 holdings. Diversification is not about how many different things you own, but how different the risks are in the things that you own.

An investor will achieve better performance by knowing a lot about a few investments than by knowing a little about each of a great many investments. This is consistent with Warren Buffett’s “Punch Card” approach.

Hedging

Hedging can be an effective strategy to reduce risk of loss. When the cost of hedging is reasonable it can allow investors to take advantage of opportunities that would otherwise be too risky. An example of hedging might be selling interest rate futures to reduce downside risk in a portfolio of interest-rate-sensitive stocks.

Trading

Trading is the process of taking advantage of bargain opportunities when prices are significantly discounted from underlying business value. When such opportunities do not exist, trading tends to be detrimental to investment success.

Buying

It is crucial that investors develop an appropriate reaction to price fluctuations. When prices are falling, investors must resist the tendency to panic. When prices are rising, investors must resist the tendency to become overly enthusiastic.

Are you willing to average down on a security, or buy more at lower prices? If not, you probably shouldn’t buy it in the first place. Consider buying a partial position in new holdings so you can average down if prices decline.

Selling

Spotting bargains is often easier for value investors than knowing when to sell. It’s impossible to know exactly what a security is worth, so how can investors be sure when the gap between price and underlying value has disappeared?

Fortunately there’s one simple rule for selling: all investments are for sale at the right price.

Decisions to sell must be based on your best estimate of underlying business value, and how the price/value gap with your current holding compares to other investment opportunities. Investors might also consider the tax treatment of gains when making selling decisions.

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