Father with 80 Kids
Assume a father has a family of 80 children (let’s not get into the details of how he fathered so many)
How would his attention be divided among the children? The kids would all be competing for the father’s attention. Being human, his attention would turn to the ends of the spectrum:
- the naughtiest, noisiest, most disruptive children or
- the best performing kids, prize-winner types.
Let’s assume that there are 5 kids on each side for the naughtiest and 5 for the best performing kids. What about the remaining 70 kids? They are doing their own thing and not noticed by their father? These 70 kids make up the majority of his family but they attract the least time and attention.
Attention deficit in your Portfolio
In a typical portfolio of securities the same principle applies. When portfolio managers construct a portfolio of securities, their attention is likewise diverted to the 2 extremes. Either the stocks that move up a lot in a very short period or those that drop very significantly. Or worse, the company’s stock has been suspended by the stock exchange. This is like receiving the dreaded call from the school discipline master, complaining about one of your kids fighting in school. These stocks will receive attention. The portfolio manager may choose to do something or nothing. Like the father who may discipline, or praise his child.
When a stock drops dramatically by 50%, the weight in the portfolio will also shrink by the same amount from let’s say an initial 6% weight to 3%. So the impact on your portfolio diminishes as the stock goes down. Vice versa the opposite happens to the stocks that double.
What about the remaining stocks in the portfolio? There are sitting there giving you a 1-2% dividend yield but are not moving much. We buy them at $1 per share and it may hover at this level for 3 quarters, 3 years and eventually 10 years! The stock barely moves up from its $1 cost price. Is that a good or bad outcome for your retirement? How many such stocks sit in a typical portfolio, dragging down returns?
Status Quo Stocks
This is the most insidious type of investing. These stocks become stagnant positions. They attract little attention or love. They tend to become lost “children” over time. If this is a large part of the portfolio, like the 70 children, this becomes a problem. The opportunity cost to the portfolio is very high.
Status quo bias is an emotional bias, it is a preference for the current state of affairs. (Samuelson, & Zeckhauser, 1988). In psychology, this is a type of cognitive bias in which people exhibit a preference for the way things are. Sometimes the status quo may not be the most rational decision.
“To do nothing is within the power of all men”
Status Quo in other areas of life
In politics, the status quo bias explains the conservative mindset where traditions are maintained. This avoids the risk of change whether it’s for better or worse.
In large organizations this happens too, old traditions that don’t make sense still persist.
In personal finance, leaving a disproportional amount in a low yielding cash account.
In health, humans often make take the path of least resistance which is doing nothing. Even though the status quo leads to a worse outcome. Medical non-compliance or in simple English – not following the doctor orders, cost healthcare systems billions of dollars a year.
Some habits are hard to change like binge watching of Netflix for 4 hours. How about taking a half an hour walk on the treadmill and watch your favorite movie at the same time?
The solution in portfolio construction and investing
When we construct portfolios at 8VantEdge, we ask ourselves is there is a way to reduce the percentage exposure to such stagnant situations? Can we bring these down over time? Instead of having many stocks that are stagnant, can we systematically sell them and replace them with stocks that are more productive.
To this end, we rank our universe of investable stocks. The longer the security is stagnant over time the smaller the weight of the stock will be in the portfolio. The ranking algorithm would require us to sell down these positions overtime reducing the exposure. It is better to cut them early and replace them with better opportunities out there. Time is our biggest enemy in portfolio management. The longer we wait and not do anything the more likely, we are missing out on other winners.