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Sunk Cost and Portfolio from Scratch

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We all make mistakes. The poet Alexander Pope wrote that “To err is human, to forgive divine.” Our blunders are often most easily seen in our investment records. The market does not care about our opinions or views. It is a challenging taskmaster.

Understanding Sunk Cost

Even though making mistakes is an inherent part of being human, most of us often refuse to recognize the errors we make. Instead, we identify our self-worth and define ourselves by what we said and did in the past. 

An example is investing in a security that turns out to be a dud. Instead of accepting the mistake, we often double down. We refuse to admit the error; we do not sell the lousy investment and make up all sorts of excuses for keeping this investment.

The better way to proceed is to recognize the past mistake as a “sunk cost.” A sunk cost is an expense or an investment that has been made in the past. There is nothing we can do about this. Time travel to the past is an illusion. The mistaken cost has “sunk” deep into a stream that has gone far away from us. 

Once we recognize that the past cannot be undone and that the cost has already been incurred – we can profitably look at what future actions we can now take. The past should not tie us down. Instead, we focus on prospective investments made now and for the future.

Portfolio from Scratch

The great fund manager, Anthony Bolton, had a refreshing strategy in dealing with the past and especially with sunk costs. Periodically Bolton used to sit down and imagine the portfolio of investments he would have today. He wholly and consciously ignored his existing portfolio – investments he made in the past. He called this strategy “portfolio from scratch.” 

If his brand new portfolio included some of his past investments, he kept those old investments. Otherwise, he usually sold out of the old investments, always taking transaction costs into account. 

In this manner, the past investments were all looked at as sunk costs. As a result, he could analyze with greater clarity what investments he should have today without being affected by his bias as to his past actions.

Two further requirements for pursuing Bolton’s strategy are (1) while creating the new portfolio from scratch – take your time, think deeply, consult widely and analyze carefully (2) do the exercise of “portfolio from scratch” once a year. This should not be done too often because you need time to learn from your mistakes and take time when setting up the new portfolio of securities.

Applications to other parts of our lives

Bolton’s portfolio from scratch strategy can also be applied to other parts of our lives. Our actions in the past are also sunk costs. The philosopher Daniel Dennett writes that “Making mistakes is the key to making progress. When you make a mistake, you should learn to take a deep breath, grit your teeth, and then examine the mistakes as ruthlessly and dispassionately as you can manage.” Then once this analysis has been made, refresh your mind, think through options and make a new beginning.

Wishing all the readers of this article and all customers of MSFL a very happy, healthy, and prosperous 2022.

© Kaikhushru Taraporevala

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