Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 574

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:

  1. Best ideas only
  2. Position size matters
  3. Be greedy when winning
  4. Materially adapt when you are losing
  5. Only invest in liquid stocks

The five losing habits of investors included:

  1. Invest in lots of ideas
  2. Invest a small amount in each idea
  3. Take small profits
  4. Stay in an investment idea and refuse to adapt when losing
  5. 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.

 

James Gruber is the Editor of Firstlinks.

 

9 Comments
Kevin
August 26, 2024

Doing a bit of checking while it rains the Bessembinder study has an opposite study. I have it on my phone.The S+P 500 back to the probable top of the market in 1928. Too many columns to see on the phone in one hit.Bonds,corporate bonds,bills ,T bonds and gold etc. I haven't noted the author but I think it is a NYU professor You may know of it.All dividends reinvested.

The value of $100 from 1928 for S +P. That went to $143 one year later. By 1932 it was down to $50,I thought bottom was 1933.

After the tech wreck it was $98,000 (2002).From then to end of 2023 the growth is huge,from $98K to $787K.That surprised me,I thought this century has basically been flat line for indices ( non accumulation),I knew the 500 had done well though.

Gold ( I can't see why people buy it) $100 in 1928 had gone to $314 by 1970.Held back by the gold standard?. "Floating" gold from 1970 to end of Dec 2023 had gone from $314 to $10K.So around 4 ounces of gold held for 96 years ? The S + P compounding at just under 10% for that period of time.

This led me to discover tobacco industries.When we had Huntley's data disc at the library one of the stand out companies on the ASX was WD + HO Wills.I can't remember the numbers but they were huge from 1980s to whatever year that disc was. Checking other things turned up Phillip Morris,which may be part of Altria now,I don't know ( Altruim?).A $1000 investment in Morris in 1925 was worth ~ $1 billion by 2012.

The only lesson that history teaches us....

The facts don't fit in .......

Short version do you want to be right.......

A lifetime of ,you can't do that.Long term investing is 3 to 5 years. Rebalance, churn your portfolio,etc,etc etc

I'm glad my portfolio is very simple,I just need to multiply a number by 2 and see how close I was decades later. Oops hang on ,forgot,it is important to get things precisely wrong to 3 decimal places.

See if you can find out about that study James,if I have put the name of the author in a "safe" place I'll never find it unless I fall over it.I'm almost certain it was a New York ( state?) University study

Kevin
August 27, 2024

Still raining so I googled it. NYU Stern school of business. Aswath Damodaran.

One of the courses was a BS in business.Made me laugh,perhaps very descriptive

James
August 25, 2024

Another great, insightful book on investing behaviour is Morgan Housel's "The Psychology of Money".

Barry
August 25, 2024

I love that book. I read it about 3 years ago. It's a very good book which shows how human biases destroy returns if people unknowingly use the default human biases that they are born with (especially the rabbit, where they tell themselves some story that it was a good stock in the past and they refuse to let go of their story in their head which no longer matches reality).

Ian Radbone
August 24, 2024

This is so painful. The metaphor of a raiding rabbit is a bit hard to imagine, but that's me!

Kevin
August 22, 2024

All true,with slight variations.Why bother splitting hairs.

People see what they want to see,the old if the facts don't fit in with what I want to see,the facts are wrong

People are totally irrational,I quickly worked that out.Things they thought decades ago they will defend that to the death .They will never say ,yes,I got that wrong.

The myths they create about " rich people".To keep it simple and not complicate it with share splits then J Bezos had 1 billion shares of Amazon on issue @ ~ $16,he was worth $16 billion. Fast forward,I don't know what the ANZ stock price is today ,he has 1 billion shares worth $200 each,he is worth $200 billion. Why would people deny that for an entire lifetime.

16 X 1 is 16. 200x 1 is 200,they'll still deny it.You must save up,you must $ cost average etc. If I'd leveraged up,borrowed $1600 and bought 100 shares I'd now have 100 shares worth $200 each The rich got richer,I got richer.They'll deny it.

The definition given ,the connoisseurs ( well done spell check),that's me. Keeping it simple all bought in the 1990s,all with the DRP used until retirement,then pared back. The share price will double over a period of time,as will my shareholding,I selected 12 to 13 years for that to happen.Knowing I would be wrong .If it was roughly right I would be an investing genius.

$6 each for a CBA and a NAB. 36 years later they may have doubled 3 times.I need to be able to multiply a number by 2,not a lot of people can do that.

Start at 6,then 12,then 24,then 48,go for broke and what the hell round it to $50 ( or down to $40,sequencing risk as they like to spruik).
I was spectacularly wrong,and even more spectacularly roughly right. CBA at ~$135,NAB ~ $35.How and why did 99% of people get that wrong .Why do they refuse to say ,yes,I got that wrong. Every day in the future when I can get it right to within $50 K probably,just by multiplying 2 numbers together ,99% of people ( at least) will still say ,no,that's wrong.

An old saying.They lock the sane people up in asylums so the insane people can get on with destroying themselves.
Raining,I'm bored,can't wait to get out. 5 years old all over again

DavidMC
August 22, 2024

Very interesting, thank you. Investor psychology is so important. Having been an "amateur" investor for nearly 60 years I liken share traders and investors to a flock of birds which will suddenly change direction en masse. One guideline which unfortunately I have never followed is when I have looked at my portfolio and thought how clever I am, look how much money I have made recently, the market invariably takes a tumble. It is rarely possible to pick the top of a share or theme, but if the price rises rapidly then starts to reduce, that can be an indication to sell and keep at least some profit. Afterpay and lithium producers have been examples of this. Also more recently uranium miners and ETFs although rightly or wrongly I have held on to these.

Deo
August 24, 2024

How did he arrive at the conclusion to bet on only a few ideas when every participant was limited to owning 10 stocks?

Kevin
August 25, 2024

Perhaps 10 would a few when compared to a well diversified portfolio.I only have 3 or 4 more than that. Split into 2 lots then the big 4 and Macbank and Suncorp. Two fired and the rest probably slightly better than average.Suncorp has been the weal link since the GFC when they were found out.Allfinanz wasn't the future..From ~$22 at a peak and dividend of ~ $1.20 a share down to around $5 and 20cents a share,I wasn't t paying attention when they plunged,I was looking at other companies and frantically wondering how I could reduce debt.

The other group then Wesfarmers has been wonderful,the rest slightly better than average.The disaster was Lend Lease.A star performer through the 1990s,rocketing up and they had a share purchase plan.Then you could only buy $3000 worth without issuing a prospectus.So every dividend you could spend a further $1500 on shares at the DRP price. I need to check but I think it outperformed CBA throughout the 90s. Then it changed. No more S Hornery and Dick Dusseldorp. They sold out of WBC and split the shares.Returned a lot of money to shareholders,everything I'd spent on them,or a few$$ less. Then I think MLC went to NAB,I don't recall what happened there,so it was probably small.

They limped along doing nothing ,then collapsed. I'm waiting ( dreaming) they might get back to $10 and I'll sell.I'd be 99% certain if they did get back to $10 then I'd be thinking,a bit longer,they might go to $11.
All up a concentrated portfolio, 4 fired, the rest slightly better than average probably,and a disaster. Decades of people telling me you can't do that,strong "expert advice" I was a disaster waiting to happen.A book of hypotheticals and what ifs that is bigger than the planet. Everything worked out great. Use the DRP and buy on the dip. Didn't always buy on the dip,there are very frightening days/ weeks until you realise that is normal. Perhaps 10 years into the journey?.
The worst thing was the best teacher,the GFC.

 

Leave a Comment:

     
banner

Most viewed in recent weeks

An important Foxtel announcement...

News Corp's plans to sell Foxtel are surprising in that streaming assets Kayo, Binge and Hubbl look likely to go with it. This and recent events in the US show the bind that legacy TV businesses find themselves in.

Welcome to Firstlinks Edition 581 with weekend update

A recent industry event made me realise that a 30 year old investing trend could still have serious legs. Could it eventually pose a threat to two of Australia's biggest companies?

  • 10 October 2024

The quirks of retirement planning with an age gap

A big age gap can make it harder to find a solution that works for both partners – financially and otherwise. Having a frank conversation about the future, and having it as early as possible, is essential.

Welcome to Firstlinks Edition 578 with weekend update

The number of high-net-worth individuals in Australia has increased by almost 9% over the past year, and they now own $3.3 trillion in investable assets. A new report reveals how the wealthy are investing their money.

  • 19 September 2024

The challenges of building a portfolio from scratch

It surprises me how often individual investors and even seasoned financial professionals don’t know the basics of building an investment portfolio. Here is a guide to do just that, as well as the challenges involved.

The everything rally brings danger and opportunity

Most market players today seek quick rewards and validation of opinion. Outsiders willing to combine new technology with old-fashioned patience and focused analysis can prosper.

Latest Updates

Retirement

The quirks of retirement planning with an age gap

A big age gap can make it harder to find a solution that works for both partners – financially and otherwise. Having a frank conversation about the future, and having it as early as possible, is essential.

The everything rally brings danger and opportunity

Most market players today seek quick rewards and validation of opinion. Outsiders willing to combine new technology with old-fashioned patience and focused analysis can prosper.

Investment strategies

Portfolio construction in the real world

Building a portfolio is like building a house. This framework can help you move towards your goals without losing sight of reality or leaving yourself vulnerable to market storms.

Shares

Feel the fear and buy anyway

In this extract from his new book, the co-founder of Intelligent Investor reveals how investors can avoid critical mistakes and profit from opportunities in collapsing share prices.

Investment strategies

The risks of market concentration and not staying invested

MFS chief investment officer and CEO elect Ted Maloney talks market risks, similarities between Trump and Harris, and the most important thing investors can do to avoid destroying value.

Gold

Gold's important role as geopolitical tensions rise

Equity markets have traditionally struggled at times of sustained geopoltical tension. Gold, on the other hand, has thrived and can provide investors with protection against "unknown unknowns".

Strategy

The changing face of finals footy and the numbers behind it

A well-meaning AFL rule change in 2016 seems to have had unintended consequences. The top teams might cry foul but AFL bosses are unlikely to be too miffed about the outcome.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.