Editor's note: In today's Weekend Edition, we're taking a break from our usual routine to share a chapter from Empire Financial Research founder Whitney Tilson's upcoming book. In this essay, Whitney shares the mistakes he made as an up-and-coming hedge-fund manager on Wall Street – along with five tips to make sure you don't repeat them...
When I first started investing in the mid-1990s, I thought that all I had to be was a good stock picker to achieve my goal of market-beating returns over the long run.
Boy, was I wrong!
Over time, I learned (mostly the hard way) that portfolio management is just as important as the stocks you pick.
Early in my career, I was so inexperienced that I didn't really understand what it meant to be a portfolio manager.
I simply bought the cheapest 10 or 15 stocks I could find and didn't hold much cash. The thought of short-selling never occurred to me. I was only vaguely familiar with what an option was, and I didn't know a thing about trading on margin.
On occasion, I developed conviction about something like the dot-com and housing bubbles and took some steps to adjust my portfolio accordingly.
But at the end of the day, I was just a plain old bottom-up stock picker on the hunt for a dozen or so cheap stocks, and that was it.
Had I just stuck with this simple approach, I would have done well. Instead, I strayed from that approach. Over time, I made terrible mistakes in every aspect of portfolio management. In today's essay, I'll show you exactly what I learned...
- Be careful with exposure and margin.
Banks and brokerages are generally delighted to lend you money. If you have $100 in your account, they might lend you $50 so that you can buy $150 worth of stocks. This can magnify your profits... and your losses.
Worse yet, banks and brokerages keep a close eye on your account. If your losses start to pile up, they can give you what's known as a "margin call," forcing you to quickly sell and raise a certain amount of cash (or they'll do it for you).
This is what happened to me in 2011 when I was running my hedge fund. My business partner and I had allowed our exposures to creep up to 136% long by 63% short that summer. In July and August, the European debt crisis caused turmoil in what had been complacent markets. In a matter of weeks, the S&P 500 Index fell nearly 20%. Our fund fell even more than this because we were trading on margin, and some of our stocks got hit especially hard.
Normally, that would've been OK. We had a strong stomach for volatility. In fact, we embraced it because it gave us good opportunities to both buy and sell at attractive prices.
Thus, we were eager to take advantage of the sell-off. (Our instincts were correct, as the markets swiftly rebounded.) But at precisely the time we wanted to back up the truck, we were instead forced to sell because we got a margin call in August.
Our fund got crushed, falling 13.9% that month. In total, from July through September, we were down nearly 26%, nearly double the loss of the S&P 500. It took us years to dig ourselves out of the hole we had created.
- Limit your number of positions.
This is the next tenet of proper portfolio management.
At our hedge fund's peak, we were wildly overdiversified with 41 long positions and 87 short positions. Even two experienced investors like us couldn't possibly have a deep knowledge of and closely track that many positions.
You don't need to own more than 10 or 20 stocks. That's a good number to be reasonably diversified, while also being concentrated in your best ideas.
- Size positions carefully.
We made another critical mistake back then. We had oversized positions in some of the riskiest companies in our portfolio, most notably a 14% position in clothing retailer JC Penney, an 8% position in satellite company Iridium, and a 5% position in Spanish media firm Grupo Prisa.
In general, I've found it's best to put no more than 5% to 6% in even the bluest of blue-chip stocks. For smaller, off-the-beaten-path stocks, I recommend sizing them even smaller, in the 3% to 5% range.
- Resist the urge to over-trade.
As we got into a hole, we ramped up our trading, churning the portfolio. Our goal was, of course, to turn around our portfolio's performance. In reality, we only made things worse.
Countless studies show that the less trading you do, the better your returns are likely to be. Here's a funny story that underscores this point to an extreme...
Nearly two decades ago, my sister set up a retirement account at the company she worked for at the time. Every two weeks, she had money withdrawn from her paycheck and automatically invested in the S&P 500.
Then, she switched jobs and forgot about the account, so she didn't make a single trade or investment decision for more than 15 years.
She recently switched jobs again, which reminded her to check that old account. She contacted her former employer's human resources department and discovered that it had compounded into a small fortune.
The irony is, had she remembered she had the account all along, she probably would have done something dumb like sell and go to cash at the market bottom in 2009.
- Know when to add to, hold, trim, or exit your positions.
This is the most important – and most difficult – element of successful portfolio management.
I didn't do this well. In 2011 and in subsequent years, I rode my positions in JC Penney and Iridium lower and lower, taking big losses before finally exiting, and watched Grupo Prisa eventually go to zero.
I sold finance giants Citigroup (C) and Goldman Sachs (GS) far too early, as well as tech giant Microsoft (MSFT), watching their shares march higher for years to come.
But the biggest portfolio-management mistake of my life was, ironically, in one of my biggest winners... I trimmed and then sold my position in streaming company Netflix (NFLX) far, far too early. It's so painful to know that had I only done one thing – held the stock of the decade, which I nailed at the absolute bottom – it would have made up for all of my other mistakes... and then some.
Instead, I took some profits when Netflix went up 50%. When it doubled, I trimmed some more. I kept trimming as the stock went higher and higher, always keeping it a 3% to 5% position. By the time I sold my last shares, it was up 600% from its lows.
I was so proud of myself for this super-successful investment...
But then the stock rose an additional 600% from where I exited. I left millions of dollars on the table by being too quick to take profits, focusing more on the rising stock price rather than how well the business was doing... It's a mistake that still haunts me to this day.
If there's one portfolio-management lesson I want to leave you with, it's this...
You must let your winners run.
In an investing lifetime, you'll only have a few opportunities to own moonshots like this. Identifying them and then maximizing the profits can make up for a lot of mistakes.
Editor's note: The Dow Jones recently hit 26,000 for the first time since the market took a nosedive. During the recent Recovery Investing Event, Whitney explained why it's time to get back into stocks... and how to do it with the least amount of risk. He also shared his No. 1 stock idea to get you back on the road to recovery. Until tomorrow, you can still catch the FREE replay right here.