Being right versus making money

If I look back on my investing over the past 25 years, especially early on, one recurring theme has been a desire to prove that I’m right. That I’m right and the market is wrong. That I’m right and another investor is wrong. That my thinking and logic is superior to others. That I know something that other investors don’t.

In a way, it makes sense. As a buyer of an asset, I’d like to think that I have some kind of edge versus other investors, especially those who are selling to me. However, taken too far, the desire to be proven right can be costly.

That desire has led me to hold onto losing stocks for too long. It’s led me to double down on losing stocks which never recover. And it’s led me to sell stocks which are up 50%, because I’ve been proven ‘right’, only to see these same stocks rise a further 200%.

The desire to be proven right reflects my personality. I often see things in black and white, which results in an ‘us-against-them’ mentality, stubbornness, and being judgmental. Though I’ve managed to temper these traits through the years, they’re still there, waiting to express themselves if allowed.

We all have cognitive biases

We all have cognitive biases or blind spots. A cognitive bias is the tendency to make decisions or act in an unknowingly irrational way. In my case, the desire to be proven right is known as confirmation bias. This bias essentially means that my brain, like everyone’s, loves to be right and I’ll interpret any information as evidence to support what I already believe.

If I think a company has a fantastic future, I’ll tend to take any new information about the business as evidence to reinforce my positive view. That’s irrational, and in investing, it’s dangerous.

Cognitive biases, and how they relate to finance, comes under the umbrella of behavioural economics. This field of study has become increasingly popular in the investing world over the past few decades.

It’s great to be aware of psychological biases, yet the crucial part is to prevent these biases from impacting what every investor is trying to do: to make money.

What things can we do to protect ourselves from our worst instincts? I recently happened upon a book which gave some fascinating insights into the best ways to do this.

The Art of Execution

The book in question is The Art of Execution by Lee Freeman Shor. Shor is a former fund manager at UK-based Old Mutual Global Investors.

Between 2006 and 2013, Shor ran a ‘Best Ideas’ portfolio. He gave 45 of the world’s best investors between US$20 and US$150 million each. He had two conditions: that they own a maximum of 10 stocks at any one time, and that he had complete transparency into each trade and investment that they made.

Over the seven years of the fund, the 45 managers made 1,866 investments and 30,874 trades. Shor’s study of what the managers did is the basis for the book.

Some of the initial findings surprised Shor. The managers, regarded by him as the best of the best, made money on only 49% of their investments. Some had a success rate of only 30%. Yet, despite this, almost all the managers made money overall.

Other statistics from the study include:

Out of the 941 losing investments, 2% lost more than 80% and 14% lost more than 40%.
Of 131 investments that fell more than 40%, only 21 went on to return over 100% from the bottom. None broke even overall.
Only 11% of winning stocks gained more than 50%. Only 1% returned more than 100%. A strict adherence to price targets was the leading reason why there were so few big winners.
59% of the losing investments made money after they were sold.
64% of losing investments were sold within 6 months, 42% were sold within 3 months, 17% were sold after one year.
66% of winning investments were sold for a 20% profit or less. Of those, 61% rose after it was sold.
Only 1% of investments returned over 100%.
68% of the time managers sold for a profit if a stock outperformed the benchmark by up to 23%.

Out of this mass of numbers, Shor found a pattern: the performance of the managers was largely dictated by what they did after they bought a stock. Though the initial purchasing decisions were important, what mattered most was how these managers dealt with winning and losing positions over time.

The 5 types of investors

From his analysis, Shor broke down investors into five categories based on how they reacted to winning and losing positions. Investors dealt with losses by being either ‘Rabbits’, ‘Assassins’, or ‘Hunters’. And investors reacted to gains by either being ‘Connoisseurs’ or ‘Raiders’.

The Rabbits. The Rabbits did nothing when they were losing money. They failed to avoid massive losses and their returns were hurt from it. Shor said what these investors had in common was the ability to justify their losing positions, no matter what:

“They were capable of constantly adjusting their mental story and time frame so that the stock always looked attractive … it never ceased to amaze me how many times the same two villains popped up in the stories told by Rabbits harboring a losing position: Mr. Market (‘The market is being stupid’) and his sidekick Mr. Unlucky (‘It wasn’t my fault, I was unlucky because of XYZ that no one could have foreseen’).”

Some of the statistics previously quoted show that when stocks go down a lot, most never come back. That makes staying pat with a losing position a bad idea. According to Shor, it’s better to take action, by either cutting the position, or increasing it.

The Assassins. The Assassins had to discipline to quickly sell losing positions. They created two preset rules that dictated what they did with losing stocks:

Sell at a preset loss percentage – most were between 20-33%.
Sell after a preset time – six months was the average time. If a stock price was stagnant or not recovering by the preset time, the company was sold.

Shor quoted a 2006 academic study which found that the highest returns were earned by investors who sold out of losing positions the most.

The Hunters. The Hunters were investors who increased positions when they were losing money, and consequently averaged down. Many had a preset plan to average into an investment. They initially bought a small position in the stock, and if it rose, it likely stayed small. If the price fell, they often bought more. Many investors added to their positions after a 20-33% price decline.

Some even had preset rules for new positions, buying one third of the amount for an initial position, one third of the amount if the price fell to a certain limit, and one third if it fell further.

Unfortunately, Shor doesn’t detail how the Hunters’ strategy performed overall.

However, he does suggest that investors should seek to be Assassins or Hunters when losing money on a stock and avoid being Rabbits at all costs. To do this, he believed that it’s important to have a plan, the discipline to stick to it, and a bias to action when confronting a losing position.

Shor also broke down the managers into two categories – Raiders and Connoisseurs – based on how they handled winning investments.

The Raiders. These investors often sold positions too early for a small profit. This meant they missed out on larger gains. But it also resulted in them having to find alternative investments or sitting unproductively in cash. Raiders had a high success rate with their investments but failed to make much money because their gains were too small, and a large loss often wiped out those small gains. Worse still, many of the stocks that they sold early went on to make much larger gains afterwards.

Shor said academic studies showed that cutting winners was a bad strategy:

“Stock market returns over time show kurtosis, which means fat tails are larger than would be expected from a normal distribution curve. This means that a few big winners and losers distort the overall market return – and an investor’s return. If you are not invested in those big winners your returns are drastically reduced.”

In other words, don’t be a Raider.

The Connoisseurs. These investors let their winners run. Interestingly, the Connoisseurs had a lower success rate, with four out of ten positions making money. However, their winners won big, and made enough to cover the losers, and then some.

These investors had a process which helped them with winning positions. They were either quick to sell losers or comfortable adding to positions at lower prices which ended up being winners. They also gradually trimmed winners by taking small profits over time.

In sum, Shor thought that investors should strive to be Connoisseurs when making money on a position and Assassins or Hunters when losing money. Based on his study, investors should avoid being Rabbits or Raiders.

The winner’s and loser’s checklist

Shor distilled his study into what he termed the habits of success. He said the five winning habits of investment titans included:

Best ideas only
Position size matters
Be greedy when winning
Materially adapt when you are losing
Only invest in liquid stocks

The five losing habits of investors included:

Invest in lots of ideas
Invest a small amount in each idea
Take small profits
Stay in an investment idea and refuse to adapt when losing
Do not consider liquidity

Lessons for the individual investor

You can agree or disagree with Shor’s conclusions, though there are some broader lessons for individual investors from the book.

Shor’s premise that a key marker for whether investors make money is how they react to winning and losing positions is powerful. It means that having an investment plan is fine, but how you execute it is more important.

Having checklists, as Shor urged, is useful. They can help maintain discipline, reduce emotional decision making, and create winning habits, in Shor’s words.

Going back to my original desire for often wanting to be right, that cognitive bias can quickly feed into poor decision making and losing money without rules or checklists to prevent that from happening.

Therefore, my biggest takeaway from the book is that even most investors, even the very best, need guardrails to protect themselves from their own worst instincts.