Beyond The Red:

Re-Evaluating Underperforming Investments

By Paul Nicol

It is human nature to see an underperforming investment in isolation. When everything is going well, and one (or a couple) of investments in your portfolio are not doing so well, the natural desire is to dispose of the investment.

However, before making any hasty decisions, you should ask yourself: What purpose does this investment serve in my portfolio? And how does it complement other investments in my portfolio?

Here are some factors we consider when constructing a portfolio and applying a broader lens to an investment and its role in an overall portfolio.

Diversification

Diversification involves allocating capital in a portfolio among different types of investments, such as equities, bonds, real estate, and commodities, to minimise exposure to any single asset or risk. Holding various investments that respond differently to market conditions reduces the portfolio’s overall risk. This approach aims to smooth out potential losses, as some investments’ positive performance can offset others’ negative performance.

Investment style

Investment styles refer to the strategies and approaches used to select and manage investments in a portfolio. Understanding different investment styles can help explain why investments behave differently at different market points.

Prominent investment styles include:

Growth Investing

• Approach: Focuses on companies expected to grow at an above-average rate.
• Characteristics: High earnings growth, reinvestment of profits, higher volatility.
• Examples: Technology sector
• Pros: Potential for significant capital appreciation and outperformance in a bull market.
• Cons: Higher risk; may not pay dividends or pay lower dividends

Value Investing

• Approach: Involves selecting undervalued stocks that are trading for less than their intrinsic value.
• Characteristics: Low price-to-earnings (P/E) ratios; strong fundamentals.
• Examples: Established companies with stable earnings.
• Pros: Potential for long-term gains; lower risk.
• Cons: It may take time for the market to recognise value; potential for value traps

Income Investing

• Approach: Focuses on generating regular income through dividends or interest.
• Characteristics: Stable cash flows; lower growth potential.
• Examples: Dividend-paying stocks, bonds, and real estate investment trusts (REITs).
• Pros: Steady income stream; lower volatility.
• Cons: Lower capital appreciation; interest rate sensitivity.

Typically, we like a blended approach of these styles (and others) when constructing a portfolio, which combines elements from different investment styles to achieve a balanced portfolio.

Downside Capture

The Downside Capture Ratio is valuable for assessing an investment or portfolio’s resilience during market downturns. A lower ratio suggests better downside protection, which can be particularly important for risk-averse investors or those seeking to preserve capital during volatile periods.

Particularly in a bull market, underperforming investments are usually “less sexy” investments included in the portfolio to protect against downside risks in a negative market. While they may look like laggards when markets are performing well, their real value is the possible resilience they provide in far more difficult markets.

Timing

It is almost impossible to predict when share prices will rise or fall. Of course, the goal is to profit by entering the market at low points and exiting at high points. But, as easy as this sounds in theory, it is far more difficult.

You may well have an investment in your portfolio that is in the red, which is not necessarily a reflection of the quality of the investment but rather unfortunate timing. This scenario often requires patience, which can be a market-based response rather than anything fundamentally wrong with the investment.

Summary

As you can see, looking at an investment in isolation is far too easy. However, “zooming out” to consider what purpose an investment holds in your overall portfolio usually answers why you may keep that investment, even if it is underperforming for a period against other investments in your portfolio.

If something has changed the fundamentals of the investment, causing it to be negative, the decision to dispose of it is a good one. However, understanding its function in a portfolio is important if the underperforming investment still has sound fundamentals.