Stock portfolios, as all other asset portfolios, have common mistakes that investors should concentrate on fixing. The act of fixing common mistakes of portfolios is an exercise of recognising biases in decision-making and common mistakes in own heuristics.
Money Bear Club continues to explore unconventional angles in investing, and plenty of them can be found in stock investing.
Read on to find out why fixation on portfolio diversity is a common mistake, and what are the costs of having a growth stock majority portfolio.
Familiarity bias
Who hasn’t invested into a company (or at least thought about it), fully or in part, because of familiarity with its products?
Humans tend to extend conclusions to similar problems they analyse. Two stocks of similar companies, but one delivers a product which the investor buys. Out of those two stocks, the one from a company the investor has product experience with, is more likely to be chosen to own. The investor, even without recognizing, could begin to ascribe the positive qualities of the product, or the sales experience, to the whole company.
This can, both in theory, and in practice, influence the decision to invest in the company an investor is familiar with through the use of their products.
A familiar CEO or a founder of a company can also contribute to the familiarity bias. A charismatic member of the C-suite is a powerful tool not only for the marketing, but also for the investor relations of a company. The reputation of a company can influence its share price. If the CEO adds to the positive reputation of a company, the investors will be more likely to pay more for the stock.
Owning a portfolio of stocks of companies the investor is familiar with, isn’t a very big problem. However, since humans tend to buy stocks from companies whose products they use, and form emotional attachment to the products they use, owning shares of familiar companies could cloud the rational judgement of an investor.
Diversification trap
Diversification of a stock portfolio is a good move. Until, it isn’t.
The first investment advice every beginner investor receives? To diversify their investment portfolio. With stock portfolios, this advice generally means investing in the stocks of companies in different industries.
However, the strategy to diversity a stock portfolio can easily backfire. This happens if the companies in the portfolio have a similar revenue model, or, an expected response to a economic downturn.
Stock portfolio made up entirely of companies with a similar revenue model is a possible outcome of a diversified portfolio. Revenue channels can be entirely the same across companies in different industries.
A company whose revenue mainly comes from selling advertisem*nt space is not limited to the social media industry. Companies earning the majority of their revenue from business to business sales (B2B) aren’t limited to the energy industry, or to the IT industry. This means that a portfolio diversification based on industries can be a mistake, if the company revenue models aren’t considered.
A diversified portfolio, composed of stocks of smaller and larger companies in different industries, will still fail, if the companies have a similar expected response to an economic downturn.
Companies whose revenues diminish during economic downturns, and companies whose revenues still grow during economic downturns, should create diversity in a stock portfolio.
A stock portfolio solely composed of stocks whose value drops during economic downturns, will easily wipe out the gains from a bull market. A defensive stock portfolio, built for a recession, won’t deliver its best performance during a period of economic growth.
Thus, when the advice to diversify a portfolio is applied, it’s important to remember to look into two factors. They are revenue streams and the responses to changing economic conditions from the companies.
“Hype” always ends
The term “hype” has transcended the fashion and entertainment businesses, and is showing up in the context of stock trading more and more often.
In the context of the fashion and entertainment businesses, previously not very popular products, when trends change, start their fast rise to popularity. The fast rising products then are called hype products.
Simply because of the fact that a previously unpopular and largely unknown product delivers the needed qualities to the market, they become hype items or personalities. Champion, a clothing company, previously not very popular, because of the change in popular trends (a return to 90s style), became associated with hype clothing items.
Hype in the stock market refers to the previously unpopular stocks experiencing a very fast rise in their share price. Investors often supplement their portfolios with hype stocks, in expectation of very large gains in the future.
Structural change in the market (legalization of marijuana), followed by new entrants into it (the IPOs of cannabis companies), can create hype for the companies participating in it.
New cannabis companies, with not entirely clear operational models and business experience, experienced a very fast rise in of their stock price in 2017 and 2018, through an increased demand for their shares.
An overeager fanbase of a company’s product, which extends its support and loyalty to the whole company, is an even more powerful creator of fast popularity, or simply, hype. It would be amiss to not mention Tesla, whose fanbase, famous for their dedication, has worked free of charge in Tesla stores. Yet, a dedicated fanbase couldn’t do anything to help with the Tesla’s latest missed production target and losses.
A company’s success is not entirely based on the new available customers, or a loyal fanbase. A rational model of revenue, constant product and service improvement, and smart choices by the upper management, are the factors that create a successful company.
15 minutes of fame
“15 minutes of fame” mistake in stock portfolio creation is similar to the “hype” mistake, however, they have an important distinction between them.
Stocks subject to the 15 minutes of fame bias, end up in portfolios not because of their newly found fitting attributes as assets. Rather, it happens because of their overexposure in the news media.
A portfolio mainly composed of stocks which have been covered in news articles, opinion pieces or other news media, faces an uphill battle for success.
This uphill battle for success is easily recognised by comparing stock news coverage versus their share price:
In both of these examples, stock price increased as the news coverage of the companies increased. As the attention from the media waned, the share price of the stock sharply dropped.
A portfolio consisting of only a few stocks whose share price is highly affected by the media attention is not a problem. However, a portfolio, where the majority of stocks are affected by the news media cycle, can end up hurting the investor.
From another angle, this irrationality in the share price change can be exploited through shrewd moves and a tight exit plan.
It only takes to identify a stock whose share price is heavily affected by the media coverage, and to adhere to a strict exit plan. An exit plan based on the possible end of the media’s coverage, and the waning attention from the investors, can be an easy path for the exploitation of this common stock portfolio mistake.
New acquaintances…
A fresh new company. A company that revolutionizes the X of Y. A real disruptor. The usual phrases allocated to new companies are repetitive and tend to lack originality. Even without them, new companies in a stock portfolio often look like a mistake.
Stock portfolio composed mostly of new companies (<10 years old) presents a possibility to grow in value along with the companies. Who wouldn’t want to cash in the early growth of companies offering a solid future perspective?
The dot-com bubble came and went, and those who have learned lessons from it, tend to stay away from new companies without a solid product. When new companies are valued for the fast pace of their growth, rather than the consumer value they bring, it spells trouble for their future.
Overvaluation of growth is the only constant in the market nowadays.
Even if a new company would have went bankrupt without the backing of investors, the promise of growth (and only the potential of large future profits) is enough to create a favourable image for the company.
For investors with more experience, or a more risk-averse approach to investing, the overvaluation of growth is just another irrationality of the markets. For less experienced investors, or ones willing to bet on growth numbers, a portfolio of new companies can become a ticking bomb. A bomb, just waiting for larger investors to pull out or lower growth numbers to be released.
New companies tend to be overvalued. The severe share price drop during an IPO (and not even after a few months) is now a rule, rather an exception. This, coupled with the fact that growth is valued over any other factor, makes new companies in a portfolio unreasonably high-risk assets.
Hence, portfolio largely made up of new companies can be a mistake that is corrected by selling, rather than holding the stocks.
…and old friends
Let’s look at a possible portfolio of a risk-averse investor.
The investor doesn’t trust the new companies on the market.
The investor also likely believes that older companies (>20 years) have already “proved” that they can deliver stable returns. “Proved” in this case means that they have delivered more profitable rather than unprofitable quarters
This leads to owning stocks of older companies, with a proven track record of stable growth in earnings. A stock portfolio composed of mainly older companies, is created based on the stereotypes. These stereotypes are about older companies being more careful in their management, making more conservative decisions, and having a stable market share, which does not need to be taken away from other companies (as newer companies have to do).
Yet, these stereotypes can do more harm than good to the portfolio. Older, less growth capable companies, often inadvertently attract bad managers or CEOs. Boards or shareholders, demanding higher growth, often choose managers that are focused on short term solutions, or simply have ideas not relevant to the company’s problems.
Management problems, lower growth and a lack of challenges, often lead older companies to ruin. Hence, for investors with a preference for older companies in their portfolio, this choice could be mistake that can even totally wipe out their gains.
Who even needs dividends?
Growth stocks are great assets to own, when the investor is ready to either risk losing all of their investment, or to make a big profit. Yet, dividend paying stocks offer a far better value proposition than growth stocks.
The mistake of constructing a portfolio with a majority of growth stocks often befalls value investors. Accepting short term disadvantages for long term value is the heart of value investing. That’s how value investors overvalue growth stocks, and create a portfolio with a minority of dividend paying stocks.
Without investing in dividend paying stocks, investors lose out on almost-guaranteed cash flow and a cash flow that tends to increase over time. Moreover, new stocks, which are not dividend paying, often don’t even manage to keep a share price even barely close to the one set at an IPO.
In pursuit of fast share price growth, with hopes of a gains repeating recent market bubbles (dot-com, housing), investors mistakenly choose to invest in growth, rather than dividend stocks.
Without a doubt, every stock, whether it is growth or dividend paying, should be examined individually. However, because of not offering a cash flow for investors, growth stocks, unless they offer unprecedented fundamental value, should not take up a majority of an investor’s portfolio.
Creating value
Fixing common mistakes in stock portfolios is a step towards a more resilient and rational portfolio. Without biases and stereotypes affecting the end result of an investment, the desired success is more likely to occur.
Fixing mistakes, in general, is not the direct path to a nearly perfect mechanism or a tool. Yet, moving towards a better mechanism sometimes is a journey in fine tuning.
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