The Pitfall of Cherry Picking.

Two Heads are better than one.”
It Takes a village to raise a child.”
It takes 2 flints to make a fire.
If you want to go fast, go alone. If you want to go far, go together“.

These quotes support the notion that a collaborative approach will inevitably lead to a superior outcome vs individualism. So, why not extend such thinking to the concept of investing?

If famed investor “A” likes stock “X”, famed investor “B” likes stock “Y” and famed investor “C” likes stock “Z”, ‘would it not make excellent sense to own stocks X,Y and Z in a portfolio?

This is the logic employed by many DIY investors throughout the equity markets today in their quest to build the “best portfolio”. Hundreds of thousands, likely millions, of intrepid investors globally, pour over the quarterly portfolios of their favorite investment managers and zero in on the top three or top five holdings held. Then, armed with a list of the securities contained within the accounts of their 5 or 10 favored managers, these individuals embark upon the process of selecting several equities from each portfolio for their own account.

The goal of DIY keeners is to create a “super-account”, one that will best the returns of any of the singular managers, and, in the minds of many, likely also reduce the risk or volatility. After all, if one owns the top equity or three (by percentage weighting) held by mutual fund manager “A”, the top equity or three (by percentage weighting) owned by mutual manager “B” and the top equity or three held by mutual fund manager “C”; the combination of the top holdings from each manager would seem, on the surface, to be a perfect solution to the dual challenges of portfolio composition and portfolio weighting without engaging in much critical thought.

“Cherry Picking’, the process of selecting the top candidates for portfolio inclusion based upon a simple screen of the top investment positions held by a specific manager, is based upon the train of thought that goes like this:

“Famed equity investor “A” has a whopping 8% of his/her equity fund in company “X”, and since it is the #1 holding in their fund, then they must favor it above all others in the portfolio, and that’s all that I need to know to own it myself”.

Taking this logic to its natural conclusion, the DIY investor designs and builds their portfolio by placing a pro-rata percentage of their investment capital into a number of equities held by their top three, their top five, their top ten mutual fund or hedge fund managers and wait for the profits to pile up. Maybe they own 30 stocks, maybe 50, perhaps 100, but the commonality within the account is that this assemblage represents the sum total of the top holdings, in the same percentages, held by a DIY investor’s favorite managers. The rationale is that with such an impressive combination of jet engines, the account will soar. This seems a flawless plan for the creation of enormous wealth, because if two heads are better than one, then 5, 10 or 15 heads, selected from the absolute top of the investment manager strata globally, well, that’s got to be infinitely more lucrative than even using two heads, and surely better than going it alone.

But, what if, instead of assembling a portfolio believed to be a hundred jet engines, the DIY investor, instead, has purchased a package of airplane fuselages, car chassis and truck frames?

An equity is contained within a professionally managed portfolio for a reason and in a specific weighting, to be sure. In some cases, that equity might have risen in value from a very small investment, over many decades, to become the largest holding in an account. But, that doesn’t equate to the top holding in any account being the perennial top performer in said portfolio. It might be the largest position due to the fact that the remainder of the account gets the absolute heck traded out of it, leaving just a single position outlier investment, one that stands out among others. That top holding could very well be one of the poorer performers. That top holding could be there entirely due to sentimental attachment by the manager. It could be the top holding due to an unwillingness to trigger a tax bill. In fact, there are a multitude of readily explainable reasons why the #1, the #2 or the #3 holdings within any specific equity portfolio aren’t what you want to replicate.

And, what if DIY investors have an entirely incorrect assumption about the investment stylings of their favorite managers they choose to copy for the cherry-picking strategy?

In a mutual fund or hedge fund portfolio of not, those top #3 holdings that are to be cherry-picked by a DIY investor might be weighted as they are, not because they are the actual best of the account, but rather because they provide the most appropriate trading opportunities for a specific equity manager to trade around throughout any fiscal quarter. They might serve a purpose, but that purpose could be entirely transactional. In such cases, those positions are owned primarily on the basis of liquidity, with an unstated internal goal of the manager to reveal no effective net change in the position through a fiscal quarter (because filings hone in on net changes within a specific period of time, not intraday, intraweek or intramonth transaction flow.

For all you and I know, or will EVER know (until the SEC determines otherwise), any number of core positions, commented on by the global investment media as being long term investments owned by any number of self-declared “buy and hold long term investors”, can have the absolute blazes traded out of them; so long as the positions are restored by the end of the quarterly report, its all good. If one actually knew of the number of buy and hold investors who traded in and out of positions using options, swaps or day trades, it would reveal a very different picture altogether.

Yet, the cherry pickers do not know of that, they will not be made aware of it, and will make the mistake of purchasing and allocating equity capital into what are assumed to be long term investments, yet are really just high frequency trading positions mischaracterized under a marketing pretense of them being buy-hold stocks. I am intimately aware that there is a massive disconnect when it comes to a number of highly prominent and widely quoted investment managers considered to be buy and hold advocates when they are polar opposites, save for the last day of the fiscal quarter. Institutions understand the distinction between talk vs act, much of retail remains in the dark.

Institutions, who tend to see through the marketing hype of various fund companies, have largely discarded the cherry-picking approach to build a portfolio.

They understand, because they are in the same business, that a portfolio isn’t just a collection of engines, nor is it a collection of vehicle frames, nor is is an electrical system; an investment portfolio represents, using an automotive analogy, the entire vehicle, from tires to steering wheels, an engine, brakes and signal lights, all designed and assembled to do a very specific thing. Removing the engine of one car, because one considers that engine to be superior, and dropping that engine under the hood of a different car, one produced by an entirely different car manufacturer, generally requires a series of expensive and time-consuming modifications to the rest of the vehicle, simply to get that engine to run, let alone run properly. Due to the complexities involved, the idea of just dropping the best engine, the best brakes, the best chassis, from any number of disparate car manufactures, doesn’t produce a supercar, it can produce a “Deucalion” (the name of Frankenstein’s monster), entirely grotesque, aware of its shortcomings and thoroughly unhappy.

Having experimented, for close to a century, with the entirely plausible-seeming, yet entirely self-defeating notion of cherry picking equities from the top managers globally, the institutional world has largely concluded the premise as being sound on paper, but unworkable in the real world. Taking an equity or three, here and there, from various managers produces something that looks good on a spreadsheet, but won’t run for long without inordinate maintenance and might not even start.

“Well then” the chagrined investor thinks, “if the concept of cherry picking a handful of investments doesn’t work as intended, then why not combine entire portfolios of the very best equity fund managers in the world? Let’s take the top 10 actively managed portfolios and throw them together, creating my own fund-of-funds?”

The concept of a fund-of-funds represents the “cold-fusion” version of an investment idea, again, great to posit, but doomed from the start for a variety of reasons. The single greatest obstacle, one that has never successfully been overcome, is the challenge of competing styles among various managers, even in the top 10 portfolios globally. Almost any actively managed portfolio has its own style, and that style may be entirely oppositional to the style of another manager, even when both managers in question are tops in their respective classes. The good results of one, from time to time, almost inevitably get canceled out by periodic underperformance from the other, and vice-versa. The more funds added to this mix, the increased probability that performance will suffer, dragging overall results down to the mean of indexes. Polarity among management styles within accounts slows, and often fully negates, momentum. The intention at the outset of the many, many experiments was to produce an investment symphony, the result was, invariably, a jarring cacophony.

Investment firms that market the concept of “fund of funds” are well aware of this issue. They cannot reconcile it, so choose to market the product differently, not on the basis of superior performance, but of “reduced volatility” “We are aware that you won’t earn the returns enjoyed by others during rising markets, but you also won’t lose as much during falling markets”. This is marketing speak for an acknowledgement that a fund-of-funds fails to produce a superior return, and was not the goal envisioned by combining entire portfolios from the top managers globally to build momentum, to increase performance? Yet, the result for the most part, due to equity polarity, is not momentum, but rather, inertia.

Selective cherry-picking doesn’t work out at the institutional investment level. Combining entire portfolios of top managers doesn’t work out at the institutional level.

The failures of active institutional megafirms to successfully work out the kinks in what are, on paper, considered to be the two single best ideas for further improving on individual performance reports of any one equity manager should represent a rejoinder to the oft-asked question posed by retail investors:

if you had to pick just one or two stocks from your portfolio, what do you like the most?”

Because that question, always posed to professional investors from retail, represents a loaded gun. The purpose of the inquiry, posed by individuals to any number of managers globally, is designed to facilitate the ease of cherry-picking, which inevitably fails to produce the outcome hoped for by an investor.

I receive such questions, a lot, in my correspondence. It always comes up in symposium Q&A; in the breakout thereafter, variations on the theme come up in conference calls. The answer to such questions is the following:

It isn’t a question of what I like the most, rather, the question is, how does that investment fit into my existing portfolio. What is the purpose of ownership, is this a vital component to ensure that the portfolio achieves its overall intended result, or is it just a fancy decal, an accessory, a fad?”

Individual investors focus too greatly upon the outlook for any one company in the context of the overall equity market. For their own long-term good, they should shift their approach to one of a portfolio based outlook. When one can reconcile periodic outperformance/underperformance by any equity in the framework of the an overall portfolio, then they are truly a better investor and will be well on the way to financial freedom.

Two heads are better than one” fails to prove out if both heads are attached to the same spinal cord and are sharing a finite blood supply designed for a single skull; each brain might be competing against the other for dominance, or for that matter, essential nutrients. Even when, both heads have their own blood supply, the net effect may be inertia, should neither of the heads be able to reach agreement on the appropriate course of action, the goal of investing is to achieve momentum.
It takes a village to raise a child” makes no sense if the entire village is illiterate, unhealthy and unfocused. If the population of the village is suboptimal, any single, competent, capable and attentive parent could readily do a more thorough job of raising that child. Proponents of the village model seek to offload responsibility and shirk their workload, little more.
It takes two flints to make a fire” assumes that the job of preparing a fire for ignition wasn’t done correctly from the outset. If the kindling has been layered adequately, if the wood was not wet, if the proper ventilation was supplied, if the kindling was “tented”, then any fire can be lit with a single flint.
If you want to go fast, go alone. If you want to go far, go together” presumes the investor to have a lack of stamina, an inability to navigate or read road signage. What if you are in the prime of life and health, have worked your way up from sprints to mid-distance and ultimately to marathons, but the remainder of your tour group is comprised of a bunch of cripples, seniors or children? Just how far will you go with this group? You certainly won’t be able to travel quickly, certainly not far. Your total distance and pace will be limited to the capabilities of the slowest and weakest in your group and if you have run the gamut of distance races, do you need to be held back by the herd? Even in cycling, a peloton, once sufficiently behind a breakaway, finds itself unable to catch up. In any major distance or endurance race, be it automotive, marathoning, cycling, the televised finish line event does not reveal a giant grouping of athletes, bikes or cars; no, it is typically a solitary athlete crossing the line unopposed, perhaps with a secondary entrant in sight, while the pack……they are far, far behind.

More isn’t better, cherry-picking isn’t better, “if you could buy just one stock” isn’t better. No, better is better. Always consider your investment decisions, not on the individual merits of an equity, not on how much you love it, but rather, on the basis of that equity’s purpose within your portfolio. Your objective in selecting and reviewing individual equities is to build a portfolio, and not just any portfolio, but one that will best the performance of the many top returning actively managed funds, funds readily available from a wide variety of investment firms worldwide.

When you are successful in your approach, you will know it, because your overall net worth will increase, with greater consistency over time and at a measurably faster pace than you will earn by owning top funds. If, on the other hand, the results of your individual stock picks, in the context of a cherry-picking approach, fails to generate relative outperformance to the top freely available active mutual equity products on the planet, then maybe the question you should be posing isn’t:

what do you like in the equity markets right now”?

Rather, a more important question should be internalized:

Isn’t it time that I stopped beating my head against a wall?”

Portfolio composition is far more than cherry-picking stocks owned by top managers. The assemblage must be done with great care. There is a reason that DIY investors underperform, consistently and over time, equity funds, who themselves underperform indexes. Retail investors as a group face a daunting challenge to generate superior performance with any degree of consistency as compared to index funds, institutional accounts or active funds and that hurdle, based on overall returns over decades, represents a very low bar indeed.

The failure of DIY investors to generate competitive portfolio performance isn’t due to a lack of equity product; rather, it is due to the lack of training on an equally vital skillset, that being the fitting and construction of those equities into an account, the building of a complete and flawlessly working vehicle, from a set of parts. A goal of winning via shortcuts or “hacks” fails, because there are no shortcuts when it comes to investment research, investment modeling and portfolio assembly and maintenance; there is only the work.

Equity cherry-picking, at its heart, represents an opportunity cost disguised as a short cut; some, maybe most, of the equity components pulled from another manager’s portfolio will not be at all useful in your own portfolio, so the assemblage from disparate sources may leave a good many parts on the floor of your garage, unused, perhaps broken from trying to wedge them into the wrong frame, and, having been purchased without a money-back guarantee, a waste of funds.

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