What is meant by "monitoring" an investment portfolio?

The word ‘monitoring’ an investment portfolio is often associated with a negative connotation.

‘Monitoring’ sounds like speculation, gambling, trading and its associated terribly high cost.

But this is often a misunderstanding of why there is a need to ‘monitor’. There are human factors and technical factors why a portfolio has to be monitored. If the portfolio is not monitored, it is likely the investor will make irrational decisions.

Human factors why an investment portfolio should be monitored

First, human beings are emotional. You may start with a plan in mind but I guarantee you with 100% certainty that you will not carry out the plan once you become emotional. Having being in the financial industry for nearly 10 years, 100% of people I have met who become emotional gave up the initial plan. So based on history, the hit rate is 100%.

Second, it also means that if a human is not emotional, there is a high chance of carrying out the initial plan.

A human becomes emotional when there are large losses or large gains. Examples of large losses are the Black Monday that was just passed. Or the financial crisis in 2008 which was 7 years ago but seems that most people have already forgotten it.

Large gains will cause a human to be emotional too. The china market went up by a whopping 154% in just one year (as at end of May 2015 in SGD according to MSCI China A). Many Chinese investors went crazy. But when the market dropped by 30% in just 3 months (as at end of August 2015 in SGD), their insanity becomes permanent because they lost everything. See Chinese farmer invested life savings in stocks, lost it all.

Over the years I have found a simple and effective way to reduce the emotional level of investors. I didn’t read from books. Frankly speaking, I discovered it because one of my colleague does it for his high networth clients and I found the idea to be workable. So I applied the same concept to my not-so-high-networth clients.

What I do is to present the performance of an investment portfolio in a graphical format followed by very short market summary of what is happening every month. During a bear run, the graph will show a monthly negative single digit portfolio loss e.g. -2%. During a bull run, the graph will show a monthly positive single digit gain e.g. +2%. After 12 months, the losses or gains become significant. For bear run, the portfolio would return say -24% while for bull run +24%.

However, since these investors are updated every month, they would not be surprised of their portfolio returns (whether good or bad) after one year. One year would become two years and eventually many years would have passed. This method helps to force investors to really stay long-term.

It must be noted that such monthly ‘monitoring’ does not translate to frequent trading. In fact, the frequency of switching / trading drops significantly as a result of this because of the positive correlation between investors’ emotion and frequency of trading.

Financial Reasons to Monitor

If you are investing in stocks, you need to monitor due to non-systematic risk. Non-systematic risks are risks that are specific to the company such as fraud, mismanagement, insider trading or simply bad luck. This would involve reading through financial reports and doing analysis. For example, if a company is always giving out dividends but its cash flow for operation is always negative, it can be implied that the source of cash is derived from selling assets (cash flow from investing) or borrowing (cash flow from financing) – both of which are not sustainable on a long-run.

For the ordinary folks, such monitoring is too tedious. There is a better way to do it by using two simple ways to ‘monitor’ a portfolio. Let me share how I do it for my clients. I do not use stocks but I placed my clients’ portfolios into unit trusts including index funds.

The first way is to rebalance the portfolio periodically to the initial allocation. This is not a unique method and is a well-known method. But what I found is that the periodical rebalancing does not need to be very often. It can be once a year or even once in three years. Rebalancing every month is an overkill though.

The second way is to monitor the performance of each fund and compared it with the performance of its peers. What I do is that I have an automated script that runs every month which ranks three categories of funds from the highest performance to the lowest performance over a specific period. The purpose of this ranking exercise is to ensure that the funds in the portfolio do not end up in the 3^rd or 4^th quartile (the 4^th quartile means the bottom 25% in terms of returns). From my observation, I have found that funds that end up in the 4^th quartile tend to stay in that 4^th quartile for a long time. Similarly, funds at the 1^st or 2^nd quartile tends to do so for a long-time. In the financial literature, this is known as ‘momentum’ or ‘style-rotation’.

For developed countries, funds that are index funds tend to be on the 1^st or 2^nd quartile. But the same is not true for emerging market countries.

Does monitoring works?

I think it does because it helps my clients stay focus and not get emotional over short-term events.

In terms of returns I cannot guarantee it will make lots of money but here is an actual portfolio from a real client to show that the rebalancing and monthly ranking exercise does work. The black line shows the actual performance. The red line shows the performance of a hypothetical buy and hold strategy.

The black line consists of one rebalancing only. There is also another two separate transactions as the existing funds started to fall into the 4^th quartile and I have to switch to another one with a better ‘ranking’. In other words, there was only 3 transactions over the passed three years.