This post is a continuation of my earlier posts. I suggest reading The Art of Selling - Preview,
The Art of Selling - Winning the Loser's Game,
The Art of Selling - Who is on the Other Side?, and
The Art of Selling - 10 Commandments, before you read this post.
The Coffee Can Portfolio
In 1984 Robert G. Kirby wrote a paper about portfolio construction and management. He called it The Coffee Can Portfolio. The thesis of his paper was: you can make more money being passively active than actively passive.
The Coffee Can Portfolio is a buy and hold portfolio strategy. The essential elements are:
(a) concentrate on the choice of stocks that we put into our coffee can,
(b) focus on the long-term,
(c) avoid churning the portfolio.
I first read Kirby’s research roughly five years ago, and since then I have been experimenting with it. Having done that, I can vouch for the fact that it just works. To ensure that this strategy does indeed work for us we have to be mindful of:
1. When we invest in a fixed income instrument, we have a clear idea of (a) the date of maturity of the instrument and the (b) rate of return. When we invest in stocks, one doesn’t have the foggiest idea of either of these two metrics. In the stock market the maturity period is infinite or rather it is the life cycle of the underlying business. That doesn’t mean that we have to hold all stocks forever. But, we should have a reasonable idea of how long we will hold on to the stocks that we buy.
2. The corollary of 1 above is that stock selection is critical. I mean the components of your coffee can will be the deciding factor.
3. Research has been conducted on the number of names that any portfolio should include, in order to optimise portfolio returns. And it has been proven that portfolios should comprise a maximum of 25 names.
4. In terms of expectations, a thoughtfully constructed Coffee Can will beat the benchmark by up to 3 percentage points per annum (including dividends), in terms of the Compounded Annual Growth Rate (CAGR). And, those of you who think that 3 percent is too small a number, you aren’t factoring the effect of compounding.
5. Kirby has indicated that his definition of the long-term is a minimum of 10 years.
That is all there is to the ‘Coffee Can’ strategy. The reasons a Coffee Can Strategy just works are:
The Art of Selling - Winning the Loser's Game,
The Art of Selling - Who is on the Other Side?, and
The Art of Selling - 10 Commandments, before you read this post.
The Coffee Can Portfolio
In 1984 Robert G. Kirby wrote a paper about portfolio construction and management. He called it The Coffee Can Portfolio. The thesis of his paper was: you can make more money being passively active than actively passive.
The Coffee Can Portfolio is a buy and hold portfolio strategy. The essential elements are:
(a) concentrate on the choice of stocks that we put into our coffee can,
(b) focus on the long-term,
(c) avoid churning the portfolio.
I first read Kirby’s research roughly five years ago, and since then I have been experimenting with it. Having done that, I can vouch for the fact that it just works. To ensure that this strategy does indeed work for us we have to be mindful of:
1. When we invest in a fixed income instrument, we have a clear idea of (a) the date of maturity of the instrument and the (b) rate of return. When we invest in stocks, one doesn’t have the foggiest idea of either of these two metrics. In the stock market the maturity period is infinite or rather it is the life cycle of the underlying business. That doesn’t mean that we have to hold all stocks forever. But, we should have a reasonable idea of how long we will hold on to the stocks that we buy.
2. The corollary of 1 above is that stock selection is critical. I mean the components of your coffee can will be the deciding factor.
3. Research has been conducted on the number of names that any portfolio should include, in order to optimise portfolio returns. And it has been proven that portfolios should comprise a maximum of 25 names.
4. In terms of expectations, a thoughtfully constructed Coffee Can will beat the benchmark by up to 3 percentage points per annum (including dividends), in terms of the Compounded Annual Growth Rate (CAGR). And, those of you who think that 3 percent is too small a number, you aren’t factoring the effect of compounding.
5. Kirby has indicated that his definition of the long-term is a minimum of 10 years.
That is all there is to the ‘Coffee Can’ strategy. The reasons a Coffee Can Strategy just works are:
a. Our time horizon is a huge determinant of outcomes. Patience is the name of the game. Over the short-term, price discovery in an auction driven system like the stock market is driven by sentiment. Over the long-term, the focus shifts to earnings. If our mission is to invest for the long-term, then we shouldn't be influenced by short-term drawdowns and hiccups. Whether we are short-term bullish or short-term bearish about anything doesn’t matter, and it shouldn’t. By varying the time horizon for an investment, the returns can vary widely. The reason is that in the stock market game, returns are non-linear and random. When we use the Coffee Can strategy, our time horizon is 10 years. Since the default setting is 10 years, it does protect us against both, the randomness and the attendant non-linearity.
b. When we build a Coffee Can we make one long-term decision. Making one long-term decision to invest in a stock is much easier than having to make this decision repeatedly over the short-term. Reducing the number of decisions that we take, makes things easier.
c. The Coffee Can strategy is for the guys who believe in the ‘never sell’ philosophy. The risk is that we may lose everything on a single position. However, the returns on the overall portfolio more than make up for any such disasters.
d. Another in-built assumption is that one shouldn't be trying to time our purchases. The vast majority of losses in the stock market come from picking the wrong business. They don’t come from picking the wrong valuation or the wrong timing on the right business. We have to accept the mantra that position size is more important than the entry level. We should concentrate more on the per stock weight in our portfolio than on our timing.
e. By definition, a coffee can will be a diversified portfolio, not a concentrated one; a maximum of 25 names per Coffee Can. The idea behind having a diversified portfolio is to reduce risk. The only way one can compile a diversified portfolio is by selecting stocks of companies whose businesses are non-correlated. Since, the businesses are not correlated, the fortune of each individual business, doesn’t sink or swim in unison.
f. The Coffee Can Strategy is a rules based approach. Rules based strategies force us into a disciplined behaviour, hence they work. That sounds a bit too simplistic, so I will let Dan Ariely, who wrote the superb book Predictable Irrational tell us why:
The following is extracted from an interview given by Dan Ariely. You can listen to the full interview here: Dan Ariely on Irrationality, Bad Decisions, and the Truth About Lies
Rules v/s Habits
Dan Ariely: Having rules actually protects us. Imagine you invited me to do something and I said, “I’m sorry. I have a rule. I don’t give more than 10 talks a year, or I don’t do X, or Y, or Z.” You would not feel good saying, “Oh, would you please break your rules once for me?” The moment you have a rule, you basically are elevating something for yourself and for other people. You are creating a standard from it and it helps you protect yourself.
If you think about religions—religions basically create rules and that’s incredibly important for the survival of the religion. So, I think we do need to think about the areas in our life where we don’t behave well and try to create rules for them.
Shane Parrish: Why rules and not habits?
Dan Ariely: Actually, you can think about habits, rules, and rituals as a continuum. Habits are those things that we do without thinking. When you think about the standard definition, a habit is something you do without thinking. You bite your nails, or slouch, or whatever it is. You can’t have a habit of running. You don’t go running and then you say, “Oh, where am I? I have no idea. I was running.”
So, for things that are deliberate and take action, you need something more than a habit, but now you have rules and you have rituals, and there are differences between them. Rituals basically create a higher order meaning. Actually, both rules and rituals have one nice feature, which is that violating them one time, violates the principle. Right?
So, imagine you have a rule that says, “I always recycle.” If you always recycle, one day not recycling is breaking your rule. Or think about somebody like a vegetarian. If you are vegetarian, you never eat meat. It’s not that you say, “I mostly don’t eat meat.” You create this rule that says, “I never do, I always do.”
That helps you understand better where you are on this range. It helps you live according to your standards.
If you said, for example, “I’m going to eat dessert on only one out of every four days,” odds are that you would cheat yourself. You will end up eating more dessert that you wanted. But if you have the rule that says, “I never eat dessert,” or, “I only eat dessert on Saturday,” that would be easier for you to keep.
Then the most interesting one is rituals. Where rituals are, it’s not that they’re—the behavior itself becomes rewarding. If you think about ritualistic hand washing, for example, or whatever it is. You don’t have to wait for the outcome, but the ritual itself makes the behavior better. Whenever you can create the rule for behavior, and even if you give up some flexibility, it’s probably a good idea. (Emphasis added)
There are two features of a coffee can approach that make it work. The first one is the stock selection part, and the second one is the rules based part. If it were so easy, why hasn’t this strategy gained the popularity that it should have? I will try and answer this question in my next post.
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