But the time came to rebalance my portfolio, and I’m here to report that I’ve learned something new about my tactical approach: there’s a right order for trades… and a wrong one.

The position.

Aquarius Platinum (AQP) has more than doubled in price since I added to the position I’d held since before the Crash. But at 450p a share I wasn’t really expecting much more.

What’s more, above average growth in the UK stock portion of the portfolio means it’s too large for my chosen asset allocation.

The strategy.

I prefer to maintain a stake in any company I’ve owned that doesn’t give me a good reason to back out. After significant growth I’ll reduce my holding and use the profits to diversify into new stocks. So the plan was to sell half of my AQP position, hold on to the rest and buy GlaxoSmithKline (GSK).

I’ve been watching them for a while, and in the light of the current return on fixed interest investments, I estimate the dividend makes this stock worth £13–14 per share.

An additional attraction is the relative stability of these large pharmaceutical companies: my portfolio could use a little added stability considering the natural resources companies it contains.

Decision made! I’m going to move some of my money from AQP to GSK; and the remaining cash released from AQP will be redistributed to other asset classes. How hard can that be?

The tactical error.

Quite, as it turned out the Markets chose this week to teach me another lesson.

My first mistake was to get greedy: AQP was off its highs, but still representing a respectable profit, I was reluctant to sell without getting top dollar.

But wait, I’ve already got cash earmarked for incremental investment into other asset classes. I thought I’d be clever and use my spare cash to take up a position in GSK, leaving AQP to return to the highs when I could sell to replenish the cash.

My error was in the order I planned the transaction.

The aftermath.

The market fell steeply after I bought the GSK stock, and the AQP followed.

Strategically there’s nothing wrong with this, I’m in this for the long haul and I’m confident these two will recover.

Tactically I’m trapped with both stocks in my portfolio, which is even more unbalanced than before I started!

If I’d sold AQP first and it’d risen, I’d have lost out on a little profit but secured the GSK position for the dividends as planned. Importantly the portfolio would be balanced.

If AQP had dropped, I’d have secured the profit I already had and could have bought GSK even more cheaply. The portfolio would still have been balanced.

And what about the cash to meet my other investment plans?

As it is I’ve lost the opportunity to take my profit on AQP, bought GSK at a higher price than necessary, thrown my portfolio even further out of balance, and tied up cash that I could be using to buy other assets at a handsome discount.

Once again I’m humbled, and just because I failed to consider the order of my actions. Not a mistake I’ll make again.

The problem is that current approaches aren’t truly global in scale. Climate change is a macro scale problem, and as a global phenomenon it should be approached with clear singular broad brush targets in mind to which a value can be attached.

With a clear valuation, carbon can become as well established as any other asset class trading on international markets, driving badly needed investment and innovation; it’s an integral part of our energy intensive economy which can only increase in value. A few years ago most investors couldn’t consider gold to be an accessible asset class, enter the ETC.

The actual valuation price of the initial offering can be debated at our leisure in the same way as every other in the market, at least the system will have started doing it’s work.

I’m hoping that the forthcoming meeting in Copenhagen will result in a more realistic approach and scale of carbon trading, let’s hope Tony Blair’s recent optimism about the meeting isn’t misplaced.

Periodically the economy must be reset to a realistic valuation: ultimately a current Price to Book Value ratio equal to 1. At this ratio, the whole market value is based on fixed assets, and we are no longer borrowing money from the future. Unfortunately, this is highly dependent upon the methodology employed in estimating the Book Value (BV).

This permits markets to take a more confident view as to how much of the expected value is actually real: based on current value of actual assets, and how much turned out to be purely based on unrealistic expectations.

Since Capitalism is driven by the search for future returns, the boom and bust cycle isn’t a side-effect, it’s an implicit requirement and a natural consequence of realising that there are no perfect markets.

I think that this is the basis of investment, but there’s a fine line between investing and gambling. It’s a matter of risk perception and probability; professional gamblers know the value of the safety play.

There’s always the temptation to take that single large punt on a risky investment in the hope it’ll pay off big… against all rational odds.

If it succeeds, we’ve a tendency to take on greater risk in the future. Eventually probability will catch up with us, and those risks generate a single crippling loss: the hallmark of a bubble.

If we failed at the first attempt, we’re left sitting on a massive loss, so what have we got to lose? Things can’t get any worse, right? This is probably what a lot of financial stock investors were thinking whilst they averaged down.

This is a slippery slope: do you give up on these risky practices, and try to slowly walk back into profit, or take one last risk in the hope that you can make it all back at once?

Personally, I prefer to think of myself as an investor, and the slow, steady, and above all balanced approach best suits my conservative tendencies.

Housing has seen a correction from the exuberant borrowing on mortgages in the UK and USA, but an over leveraged sector still exists: government and consumer debt.

The fact is that UK and American consumers have borrowed heavily from their futures to spend on the high life of the past ten years, and the time is approaching for the debt to be repaid.

National economies will start to grow again, possibly as soon as next year, and the extra money that has been injected via quantative easing, to stimulate this recovery, will need to be removed.

Unfortunately I doubt our fiscally weakened Government can buy back all the issued debt quickly enough, and interest rates will have to rise sharply to control increasing inflation as growth accelerates.

It’s at this moment that the general public will realise how broke they really are, as loans start to be harder to maintain. As a consequence the housing market will take another downturn as people try to realise some badly needed capital.

Our currency will devalue relative to newly emerging economies, and we’re going to have to learn to live in a poorer nation than we’d like to believe, but then maybe it’ll be a fairer world.

During the last bull market, some geographical regions, such as emerging Europe and Russia, accelerated well ahead of the rest, I failed to diligently rebalance and paid the price. I’d have more money to reinvest now if I’d thought about it.

Whilst rebalancing these runaway sectors, I’ll give closer consideration to reducing my whole portfolio, maintaining the target allocation of course. Liberating cash in this way is something large fund managers can rarely do, so I intend to use this advantage next time round.

Clearly, not all corrections are going to be as drastic as the Credit Crisis, but for those lesser moves I’d aim to stay fully invested. None the less, rebalancing out performing investments and holding back new cash may be appropriate.

I hope that reducing holdings, along with the stockpiling of new cash, will enable me to capitalise on future bear markets.

I recently heard the founder of CMC Markets commenting, and I paraphrase, that traders call a bad trade an investment. At the heights of the last bull market, when M&A action was all that was sustaining prices, I have to admit that I nearly fell into this trap.

Whilst I feel that I’m confessing a sin: admitting to buying on market rumours, I avoided compounding the error by convincing myself that the stock would still be good value for the long term. It wouldn’t, the price was inflated, the fundamentals I ignored made that clear, and it was very unlikely to ever be worth what I paid for it.

Trading and investing are not the same thing, and require different strategies. Timing is important for a trade, as is close observation and the use of stop losses. An investment must represent reasonable fundamental value to be worth buying, so the precise dynamic of the current market doesn’t matter as much.

In future I’ll decide, in advance, whether I’m trading or investing.

This combination sounds a little contradictory, since asset allocation is the response to the perceived impossibility of deciding on price in a random walk down Wall Street: you can’t consistently outperform the market.

Whilst I don’t entirely subscribe to this sentiment, I believe it has good applications at the core of a portfolio comprised of these asset classes.

• Equity based mutual funds, diversified both by size and geographic region.
• Commodities based on ETCs.
• Geographically diverse corporate and government debt.
• Mutual funds directly invested in commercial property. If asset diversity is the goal, investing in property stocks doesn’t really cut it, they’re still equities.

This core represents about 80% of my portfolio, and I use fundamental analysis, alongside the actual asset distribution, as a method of timing my rebalancing and adding cash into the portfolio.

Fundamentals are key to actively managing the remaining 20% of my portfolio, which is mostly invested in UK equities, in the form of individual company stock, and both long and short index tracking ETFs.

This strategy remains unaffected by the Credit Crisis, but my execution has changed in two main respects; being honest with myself about objectives, and active use of cash within the portfolio. These will be the subjects for a couple of future posts.

The focus of this article was the fact that risk is perceived differently by different people and he offered an equation for risk.

Risk = Consequence x Likelihood x Outrage ⁽¹⁾

In investment it’s the outrage element that represents market sentiment, and it can spell disaster or opportunity.

Ever wondered at the drop in value of a high growth company’s stock when they report hugely positive results, that are only slightly below expectations?

Equally, outrage underpins contrarian investing: nobody’s surprised when a dog of a company reports poor results, but what if they’re good?

It’s not rational to expect a business to sustain double digit rates forever, and unrelated changes in long term cycles can improve the cash flow statement. The likelihood of either event may be similar, and the consequences for both company’s operations relatively minor, but the outrage, or delight, factor leads to disproportionate perceptions of risk; and hence return.

I’d love investment to be a rational activity where we could trust in the efficient market. With millions of individual human beings involved the outrage factor isn’t going anywere soon, so the only option is to try and understand it.

Reference.

1. Davies, Paul (2009) “Risky business.” The Chemical Engineer, (Issue 812), pp. 28–29.

On the flip side, those who hope to have a couple of decades of investing to come are in a much more fortunate position. I’m positively excited about the markets today, because they’re stuffed with risk, and opportunity.

Back in 2006, it was almost impossible to find company valuations that displayed any upside, most were grossly overvalued already. I was constantly frustrated for investment ideas. The bear market should have started right there, but we staggered on covered in bandages.

The recession is progressing well, and the markets are awash with value for the long term investor. I’ve always ignored analyst earnings forecasts, preferring as always to make my own decisions on the balance sheet, which probably explains why those same valuations are looking quite different now.

But markets could, and probably will, fall even lower. So we’re back to timing again! No, decide what you think is good value and take the plunge when you see it. Waiting for a falling price to bottom out before buying is pointless: you’ll probably be wrong and also miss it on the way up. And if you’re taking a long term position? You could do worst than average your way in over the next couple of years.

Whilst re-evaluating my investment portfolio in the wake of the Credit Crisis, this rule popped into my mind. I wondered if the finance industry will need to start applying it to their future activities.

The over-use of complex derivative products contributed significantly to the carnage, after all, if you can’t work out the value of an asset it seems obvious that that asset is too complicated. It’s also questionable whether some of these derivative products could ever have ‘worked’.

The complicated nature of these products allowed firms with an expertise in them to generate large profits. However, derivatives and securitized products are also difficult to value; these difficulties would eventually result in many firms having much higher levels of risk exposure than they had intended.

How does this apply to my personal investments? I’m carefully considering whether any aspects of my asset allocation strike me as too clever and what exactly my definition of ‘work’ represents.