Monday, February 07, 2005

Negative Feedback and Relative Value Investing

If I buy a stock based on long-term fundamentals and the stock goes down in the short run, my tendency is to want to buy more at the new "bargain" price, so long as the fundamentals remain intact. The drop in price diminishes the value of the stock in my portfolio, allowing me to buy more without giving me an undue amount of exposure to the stock.

On the other hand, when a stock I own rises dramatically, I tend not to want to buy more, because the stock begins to look expensive. The high price encourages me to sell some shares and thereby reduce the overexposure the rising price has given me to the stock.

In this sense, my relative value-oriented, long-term mindset towards investing has a negative feedback mechanism naturally built in. Short-term price volatility presents opportunities to buy more shares at depressed prices (good relative value) and to sell shares at rich prices (bad relative value). This mechanism adjusts exposure to individual companies in a portfolio, preventing me from becoming overexposed to any one company.

Contrast this with the positive feedback mechanism inherent in trend-following investing. If a stock rises, a trend-follower should buy more, thereby giving him more and more exposure to a single company. Stocks with losses will be sold early on. The end result is a portfolio holding just a single company, which from an asset management point of view is certainly a very precarious position to be in.

Investing strategies with built-in negative feedback provide an investor with some degree of natural diversification, thereby giving the portfolio a higher survival rate. This is one of the benefits of taking a relative value approach to buy and sell decisions, rather than being a trend-follower.

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