Avoid unnecessary diversification
Applying a bottom-up approach also helps to avoid ‘diworsification’ whereby investments are included as fillers with the intention of diversifying a portfolio but doing little to improve expected returns – even detracting from them – as well as increasing trading costs and eroding the portfolio manager’s knowledge of, and conviction in, their investments.
The importance of a bottom-up discipline in avoiding drawdowns
We have looked at the importance of constructing a portfolio from the bottom-up which emphasises the quality of cash flows in the selection of individual securities, but in addition investors must pay scrupulous attention to the changing dynamics of their holdings.
Managers must be prepared to take, often tough, decisions in a timely manner to avoid drawdowns by recognising any deterioration in the fundamental characteristics of their portfolio holdings, which determine the sustainability of future income generation. They must have the ability and knowledge to take action if red flags are raised.
By consistently applying a defensive quality-focused bottom-up approach to security selection, investment managers should be better placed to build portfolios which are well equipped to handle episodes of market weakness. This requires an intense focus on security analysis and the consideration of positions on a holistic basis, rather than in isolation. By reducing the impact of drawdowns on the portfolio, investors are able to improve the probability of meeting their investment goals over the long run.
