If You were the owner of an apartment building, would You allow tenants to stay rent-free forever ? You would probably do everything in your power to either collect or evict free loaders. In the investment realm however, one of the main reasons managers fail to accomplish their goals is that they allow free-loaders to stay rent-free in their portfolios. The difficulty then is how to identify and deal with free loaders.
- Endowment effect: once in the portfolio positions are sticky.
- How to identify and effectively deal with free loaders
- The 3 main benefits of the game of two thirds
- Calculate portfolio turnover, divide it by three: first 1/3. Add 1/3 turnover to the entry date of each position. For example, a stock entered on January 5th and a turnover of 1 would yield a cut-off date of April 5th
- Divide performance in 4 quartiles, concentrate on the third quartile: second 1/3. For all stocks in the third quartile past their anniversary date, cut weight in half
- if it starts to underperform, it will be dealt with, and this profit taking will have cushioned the blow. This demonstrates stewardship
- If it continues to go nowehere, resources are re-allocated to a potentially more productive asset. If non-performance persists over 2/3 of portfolio turnover, then a more drastic reduction is in order
- if outperformance resumes, then it will be dealt with
The game of two thirds may appear simplistic. It has however powerful psychological implications. It is a simple, powerful and objective way to short-circuit the endowment effect for three reasons:
- Simplicity: math is beyond dispute. Simple rules are elegant, easier to implement and harder to challenge
- Stewardship: great investors are not smarter, they have smarter trading habits. Getting rid free loaders builds the habit of dealing with difficult stocks
- The quality of our excuses determines the quality of our performance: one of the most frequent excuses is “what do i buy next ?” Constant re-examination of positions forces managers into action.