- We can try to evaluate the performance of the portfolio as a whole during the
period without examining the performance of individual securities within the
portfolio.
In practice, it is quite common to find people use the transaction view or the security
view while evaluating themselves or their subordinates. However, these methods though
intuitively appealing are inadequate and often misleading. Consider, for example, a
hypothetical situation where we are sitting in the training room watching two portfolio
managers place sell orders. A is selling stock X for Rs.80; he tells us that he bought the
stock a month ago at Rs.64. Mentally, we make a quick calculation: A has made a return
of 25%. Meanwhile, B is selling stock Y for Rs.72; this stock had cost him Rs.60 a
month ago. We calculate that the return is only 20%. We decide that A has done better
than B but keep our thoughts to ourselves. We come back to the trading room a month
later to find on PTI-SCAN that stock X is now selling at Rs.90 and stock Y at Rs.55. B
walks up to us and tells us how right he was to sell the stock before it started falling. We
then turn to A to remind him that stock X has risen 12.5% since he sold it. He
nonchalantly tells us that he has not been keeping his money idle and that his recent
acquisitions have appreciated even more steeply. We are left wondering whether this is
just a case of sour grapes or whether A has really been doing well.
If we think through this example carefully, we will realize that the important notion is
that of opportunity costs. The book profits that A and B made when they sold their
respective stocks is easy to calculate. The difficulty arises with opportunity costs. By
selling stock X when it was still rising, A has missed the opportunity to earn an even
higher return than he did. B, on the other hand, has avoided a large opportunity loss by
selling just before the stock fell. The opportunity cost becomes tricky when A tries to
argue that he has not suffered an opportunity loss at all because the stocks that he bought
after selling X have done equally well if not better. A’s argument, in fact, strikes at the
very root of the transaction view. He is telling us not to look at the transaction in
isolation, but to look at his portfolio in its entirety.
We shall shortly turn to the portfolio view, but the notion of opportunity costs is an
important one for all portfolio managers. There is a deep-rooted tendency among most
investors to ride their losses and book their profits. They feel comfortable selling a stock
on which they are making a book profit. They feel uneasy selling a stock if it means
incurring a book loss, and, therefore, tend to carry the stock in their portfolio in the hope
that it will some day appreciate in value. This argument is totally fallacious. In the
process of avoiding a book loss now, they may incur a large opportunity loss; in other
words, the stock may decline further causing an even greater loss in future.
The notion of opportunity loss has helped us realize the advantage of the portfolio view.
There is a second major reason for taking the portfolio view, and that is the issue of risk.
We know very well that higher return can be has if we are willing to accept higher risk.
When we say that A earned a return of 25% on stock X while B earned 20% on stock Y,
we need to look at the riskiness of these securities to evaluate these returns. The