Introduction
Over seven years from June 2006 to October 2013, the author examined 1.866 investments representing 30,874 trades made by 45 of the world’s top investors – all of whom he had the privilege of managing as part of his job as a fund manager at Old Mutal Global Investors. Each of these leading investors was given between 20 to 150 million dollars to invest for his Best Ideas fund, with strict instructions that they could invest in ten stocks that represented their very best ideas to make money.
He was shocked that only 49% (920 investments) of the very best investment ideas made money. Even more shocking was that some of these legendary investors were only successful 30% of the time. What is fascinating is that despite some of them only making money on one out of every three investments, overall almost all of them did not lose money. In fact, they still made a lot of it.
Successful stock market investing is not about being right per se — far from it. Success in investing is down to how great ideas are executed.
You do not have to worry about whether an investing idea works or not if you focus on how to invest in that idea: it is about how much money you allocate to each investing idea and what you will do when you find yourself in a losing or winning position.
It is not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.
George Soros
The author categorised the investors into tribes: the Rabbits, the Assassins, the Hunters, the Raiders and the Connoissuers.
Part I: I’m losing – What should I do?
1. The Rabbits: Caught in the capital impairment
The Rabbits did nothing to their losing investments. They ended up being the least successful investors for the author.
What the Rabbits did wrong
- Framing bias or anchoring heuristic
When people make decisions, they tend to reach a conclusion based on the way a problem has been presented.
One of the Rabbits’ mistakes was allowing their favourite types of investment to dominate how they looked at a stock. They were capable of constantly adjusting their mental story and time frame so that the stocks always looked attractive. They tend to dismiss black-swan events. - Primacy error
First impressions have a lasting and disproportional effect on a person. - Anchoring
It is dropping our intellectual anchor and letting it sink deep into a view and being unwilling to accept new findings that suggest we are wrong and should haul it up and sail the hell out of there.
If a Rabbit did eventually change his mind, it was always an achingly slow process. - Endownment bias
Large losses that occur over a short period of time are nearly impossible to accept, especially when they are significant. - The pull of the crowd
Going against the crowd makes investors nervous. Few investors are willing to be a lone voice for fear of others ridiculing them. - Ego
The Rabbits really did not like being wrong — they were, in fact, ultimately more interested in being right than making money. - Self-attribution bias: It is not my fault.
It is a key reason we do not learn from past mistakes but keep repeating them. - Confimation bias
They seek out more information to help support their “right” decision.
A hugely appealing temptation for more information comes from the need to abrogate responsibility in times of crisis.
While more information increases a person’s confidence, it does not increase their accuracy (success ratio). - Denomination effect: Too big to fail
The bigger the losses, the more nervous and indecisive most of us become. - Gambler’s fallacy: I am due a win
It is a mistaken belief that the odds for a stock have become more attractive due to recent poor performance. It is a belief that you will win after a streak of losses playing roulette at the casino — “I am due a win”.
The probability of a fair coin turning heads is always 50%. Each coin flip is an independent event and all previous flips have no effect on future coin tosses. - Amiguity aversion: Fear of the unknown
If the Rabbits sold out, the shares might rally and they would miss out. It was better to stick with the current loss than worry about that double whammy.
What the Rabbits could have done differently
- Always have a plan
When faced with a painful loss-making position, most people do nothing. They turn into a Rabbit and procrastinate, letting all their biases play havoc with their decision-making, hoping time will resolve their issues so they do not have to. - Sell or buy more
The only solution to a losing situation is to sell out or significantly increase your stake.
Ask: If I had a black piece of paper and were looking to invest today, would I buy into those stocks given what I now know? If you conclude that you would not buy the shares today but find that you cannot push the sell button, be aware that this is because of endowment bias and not a logical investment thesis. Sell.
Doing nothing when you are losing is never an option.
The Rabbits were not terrible investors just because they refused to accept they were wrong. The real giveaway was that they refused to do anything when they found themselves in a losing situation.
Losers stay losers because they fail to materially adapt. - Don’t go all in
A corollary of the previous point is to never put yourself in a position where you are still convinced by your original investment idea but are not able to invest more money when the share price falls, This is poor money management. Keep some powder dry.
This also helps neutralise the denomination effect — of feeling like an investment is too big to be changed. - Don’t be hasty to jump in, do be hasty to jump out
It is easier to get into something than to get out of it.
The bulk of investors’ losses in bear markets come in the final third of the fall (Being Right or Making Money, Ned Davis, using the DJIA from 1929 to 1998).
Cutting losers early is difficult but it makes a lot of sense. Selling out of a stock helps to clear your head and enables you to assess a situation more objectively.
The winners make small mistakes while the losers make big mistakes. - Remember, there is a difference between “being right” and “making money”
- Seek out opposition
When people lose money, they do not want to be told they are wrong. They want reassurance.
What you should really do is speak to someone with an opposing view. - Be humble
The Rabbits were often very confident and they could be compelling. They never said. “I don’t know.”
You should expect your ideas to be wrong and invest with that in mind. - Keep quiet and carry on
The Rabbits might have been less likely to get struck had they not boasted of anticipated returns. It is an unnecessary hindrance. - Don’t underestimate the downside – adapt to it
Many Rabbits love stocks that could shoot for the moon; stocks with massive potential upside if the story played out.
The solution: Invest an amount you are willing to lose. If the stock does go “bang” as opposed to “pop”, then the amount you have lost is not fatal. - Be open to different kinds of story
Many studies have shown that stocks with the worst stories tend to produce the highest returns. Over time, value investing (investing in cheap stocks that no one likes because they have bad stories that have caused their stock price to fall) produces the highest returns. - Get sick of sick notes
No one likes admitting they are wrong, especially if we have to report to a boss and explain our actions. Instead of coming up with explanations of why investments has not come right, one should do the opposite: familiarise yourself with all the well-worn excuses in advance so that you waste no time trying to fool yourself or anyone else into persisting with a mistake. - Be suspicious of status
It is dangerous to assume that just because an investment professional is highly educated and has years of experience, he or she will be good at making money and getting the big calls right.
To make money, you need to have money. To maximise profits, we have to minimise losses. You must preserve your capital. When you are losing, you have to materially adapt to migitate the situation. Permanent impairment of capital destroys wealth.
Try to avoid being blinded by your story. Have a plan of action as to what you will do if you find yourself in a losing position, even if you still think you are right.
The key difference between the Rabits and other successful investors is that when the Rabbits were losing, they did nothing. As we will see with the Assassins and Hunters, they acted decisively to bail themselves out of the holes they found themselves in.
It is not the strongest of the species that survive, nor the most intelligent but the one most responsive to change.
Charles Darwin
2. The Assassins: The art of killing losses
When it came to selling losing positions so as to preserve their capital they were ruthless, like cold-hearted hitmen, pulling the trigger without emotion. Then they carried on with their lives as if nothing had happened.
The Assassins understood that successful investing is about asymmetric returns. Winning entails ensuring that the potential upside return is significantly greater than the potential downside loss.
They knew that when faced with the uncertainty that naturally follows when the market turns against them, they could not rely on themselves to do the right thing. They therefore committed to becoming slaves to the rules. When a loss occurred, they would follow their commandments to the letter.
They planned well in advance. Before they invested, they knew what they would do afterwards. They did this because they knew that when push came to shove, they were likely to make poor decisions in a “hot” (or emotionally charged) state of mind.
The code of Assassins
1. Kill all losers at 20% – 33%
The Assassins’ rules required them to put a stop-loss order in place at the same time that they bought any shares. Stop-losses are a common practice in trading but less so in investing (and it is no coincidence that a number of the Assassins were hedge fund managers).
Most investors use “review” prices instead. If one is hit, it forces a review of the holding to decide what to do. The review is designed to wake us up and force us to take action. Reviews give us more of an illusion of control than actual control. Stop-losses are greatly preferred.
The Assassins have different stop-loss points depending on their own experience and preferences: almost always somewhere between 20% and 33%. This range of stop-loss levels avoids you getting whipsawed while giving you a realistic chance of being able to recover from the loss you incur.
Investors, unlike traders, rarely use stop-losses. Indeed, many investors frown upon them as crude instruments because they want to have the flexibility to decide what to do instead of mindlessly and mechanically selling.
Investors often overlook the beauty of stop-losses. They force action at a time when action is required.
2. Kill losers after a fixed amount of time
Time is money. Being in a losing position for too long, even if the loss is only 20% or less, can have a devastating effect on your wealth.
The Assassins’ second rule was to sell stocks that went down by any amount and showed no signs of recovery after a certain period of time. The majority drew the line at six months, but there were variations.
Large losses kill you quickly, while small losses kill you slowly.
If it feels like a struggle then you should get out.
Jesse Livermore
Don’t sell too soon.
It is important to realise that the Assassins’ rules protected them not just from indecision but from overreaction too.
Be careful on your next investment
When you sell out of a losing position, you are making two decisions:
- It is no longer a good idea to have the money tied up in that stock.
- Your money would make a better return invested elsewhere (an opportunity-cost decision).
An elusive cadre
Realizing a loss is ten times more painful than merely acknowledging it on paper. There is also the question of whether a stock might rally after we sell it. The very idea freezes many into inaction.
In life and business, there are two cardinal sins. The first is to act precipitously without thought and the second is to not act at all.
Carl Icahn
A study by Professor Frazzini supports the Assassins’ approach: the highest investment returns were achieved by those investors that had the highest rate of selling out of losing positions. Those who experienced the least amount of losing returns had the lowest returns. The losing trait of riding losing positions while taking profits on winning positions has been called the disposition effect by Frazzini.
3. The Hunters: Pursuing losing shares
Unlike the Assassins, the Hunters did not sell out of those positions—they bought significantly more shares. The Martingale approach is a gambling strategy that involves effectively doubling down. This is a winning strategy in well-chosen investments: you acquire more and more assets at lower and lower prices.
The Hunters are all successful practitioners of what is called “dollar-cost averaging.” They did not go all in on day one. Rather, they invested a lesser amount at the outset and kept some cash on the side, waiting for an opportunity to buy more at a lower price in the future. The Hunters’ approach is invariably contrarian. They were value investors.
Being contrarian
The Hunters realised that being a contrarian investor is dangerous because you are always going against the crowd. As such, they became experts at interpreting charts and other methods to truly gauge the crowd’s sentiment. It was no use buying when the crowd showed no signs of changing its mind any time soon. They also grew unafraid to sell if it became clear they really had made a mistake.
Being a Hunter requires patience and discipline. You have to expect a share price to go against you in the near term and not panic when it does. You have to be prepared to make money from stocks that may never recapture the original price you paid for your first lot of shares. If you know your personality is one that demands instant gratification, this approach is not for you.
If you are a Hunter, you choose not to control risk by diversification but by thoroughly understanding the risks and returns of a particular stock or handful of stocks. The goal is to find companies that have an unbelievably attractive, asymmetric payoff profile.
The Hunters often put 20% of their assets in a single stock and had to be comfortable investing another 20% in that same stock when it was heading south.
To be comfortable with such concentration:
- Choose to only review the position every five years or set up an alert on your trading account to inform you if the price drops by a certain threshold.
- Set up standing orders in the market when you buy your first stake in the company. It is very easy to freeze with fear when shares drop, even if it is to a price that we said at the outset we would be happy to buy more shares at.
Conclusion to Part I
- You can get big decisions wrong and still make money, provided you are willing to materially adapt.
- Focus on what you do when you are losing. You cannot change the past but you can change the future.
Part II: I’m winning – What should I do?
4. The Raiders: Snatching at treasure
These are the investors who enjoy nothing more than turning a profit as soon as possible. They occupy a thin line between success and disaster.
Investing on the edge of ruin
Raiders do not let their winners run. The author’s analysis showed that had the Raiders stayed invested in their winning ideas, they would have gone on to make a lot more money. Furthermore, because of this failure to run their winners, a few large losses eventually wiped out most of the Raiders’ small gains. They have high hit success rates but poor payoff profiles.
The most successful investors the author worked with, those that made the most money, all had one thing in common: the presence of a couple of big winners in their portfolios. Any approach that does not embrace the possibility of winning big is doomed.
The problem with the Raiders is that taking small profits is like picking up pennies in front of an oncoming train.
Why do investors sell too soon?
- It feels so good. Selling for a profit is a nice feeling.
- I’m bored. Getting tired of waiting for action is part of human nature.
- Frustration. Staying invested in a winning position is like taking the kids on a day out to the zoo but you have a two-hour car drive before you get there.
Self-control issues
We have self-control problems when faced with a decision today that is very pleasurable, like taking profits. We find it very hard to say, “No.”
Hyperbolic discounting: Various studies have shown that humans prefer $1 today versus $2 tomorrow.
Raiders are “present-biased” without realising it.
- Fear
Myopic loss aversion: The pain of a short-term loss overpowers the pleasure of a long-term gain - Short-termism
Recency bias: A natural disposition to focus on the short term
This can be deadly for winning trades. - Risk aversion
Prospect theory: Whether people are winning or losing affects how they make a decision. People are risk-averse when winning, hence, they take profits — but risk-seeking when losing.
When losing,the risk is appealing because anything is better than a certain loss.
When winning, selling is appealing because the certainty of a small victory is better than the uncertainty of a loss or greater victory.
Why you shouldn’t sell early?
- Rarity value
Big winners are rare. All the successful investors the author has managed made money because they won big in a few names while ensuring the bad ideas did not materially hurt them.
Having a process that prevents you from winning big because you take profits once stock is up 20 or 30% means that you could potentially be the person who gives away a winning lottery ticket.
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.
Rabbits and Raiders: Raiders are often Rabbits when they are losing and the combination is fatal. When you combine the desire to sell winners too soon with the reluctance to sell losers, you end up losing a lot more than you win: you have effectively created an investment style that combines significant downside risk with insignificant upside potential.
Selling winners fast and holding losers long. - Beat your rivals
The ability to run winners can give you a very easy but significant advantage over your rivals. The author finds that behaviourally many find it hard to hold onto winning investments. It is clear that if you can expand your investment horizon you can have a massive advantage. - You cannot trust your next investment
House money effect: Once a person has sold a winner, his or her behaviour turns from being driven by risk avoidance to risk-seeking. Investors view their profits as ‘house money’, not their own money. If they lose they feel they have not really lost anything. Investors need to try to break the link between success and failure in prior investments if they want to succeed. - Winners can keep winning
Winning stocks continue to win.
Caution: Winners may not win forever. Eventually, no marginal buyers are left to bid the stock price higher and a price correction occurs. - You can never predict big winners when you first invest
Many legendary investors did not predict their biggest winners and have admitted it.
Is it ever right to sell a winner?
If you know your reason for investing has been proved wrong, then you have no reason to stay invested.
5. The Connoisseurs: Enjoying every last drop
The Connoisseurs are the last and most successful investment tribe the author discovered among the top investors who worked for him.
They did not get paralysed by unexpected losses or carried away with victories. They treated every investment like a vintage of wine: if it was off, they got rid of it immediately, but if it was good, they knew that it would only get better with age.
Their strategy was to take a small bite and leave some for later, extending and maximising the pleasure of success as long as possible. Taking small profits along the journey like a Connoisseur allows us to get instant gratification without ruining our long-term wealth aspirations.
How to ride winners
In terms of hit rate, as a group, they actually had a worse record than the average for the author’s investors. Six out of ten ideas the Connoisseurs invested in lost money. The trick was that when they won, they won big. They rode their winners far beyond most people’s comfort zone.
- Find unsurprising companies
The Connoisseurs’ approach was to identify companies to hold them for ten or more years. They would buy businesses that they viewed as low ‘negative surprise’ companies — high predictability and consistency in their profit-making ability. They are effectively money-printing machines. - Look for big upside potential
The secret of the Connoisseurs was not only to do away with unambitious limits (they never used price targets) but also to eschew investments that might only ever perform so modestly. They were not interested in small-scale success. - Invest big and focused
When the Connoisseurs were very confident in an idea, they built up big positions. They could end up with 50% of their total assets invested in just two stocks. It was these stocks that made them so successful.
It is no use having a small investment in a big winner; you have to have a large position size to generate big returns.
Position size can be more important than entry price.
Stanley Druckenmiller
- Don’t be scared
The way many Connoisseurs avoided being scared out of a position or being scared out of a position or being attracted by another great investment was to take small profits as the stock kept going up rather than selling entirely out of the position having made 20% or 50%.
In other words, lest all the bottles in the cellar got corked, they would take one or two upstairs on special occasions and enjoy them. - Make sure you have a pillow
One of the key requirements of staying invested in a big winner is to have (or cultivate) a high boredom threshold.
Trimming the winners: Take small profits along the way to ensure staying invested.
Dealing with losses
Every Connoisseur was also an Assassin or a Hunter when it came to losses.
Why many fund managers are doomed to fail
- Many professional investors over-diversify when they invest because they are managing career risk.
- They believe that diversified portfolios represent less risk than a concentrated portfolio of stocks. The reality, however, is that all you are doing is swapping one type of risk for another. You are exchanging company-specific risk which may be very low depending on the type of company you invest in for market risk (systematic risk). Risk has not been reduced, it has been transferred.
Dangers of being a Connoisseur
- You can be too late
Ned Davis, using the DJIA from 1929 to 1998 showed that the bulk of investors’ returns (more or less half) in bull markets come in the first third of a rally. He also showed that the first half of a rally accounts for two-thirds of the overall return in a bull market.
The longer a rally has gone on, the greater the likelihood it is nearer to the end than the beginning. - Momentum can be illusory and end abruptly
The longer a stock has been winning and the more widespread its story has become. the more speculators will have bought into it with the view to own it for as long as the ‘trend is their friend’.
Investors seem to be hard-wired to follow the herd, so we need to be careful when riding a winning stock. People lose the ability to think rationally under the pressures of crowd behaviour. At the height of a bull market or in the depths of a bear market people become herd-minded. And it is rarely safe to be relying on irrationality for profit for too long. - You can get stuck
If someone yells fire in a theatre filled to the rafters with people, panic breaks out and people can be crushed rushing for the exits. However, if someone yells fire in a theatre filled with very few people, the people can get up, look for signs of fire and walk out in an orderly manner.
This is another reason that the Connoisseurs’ approach to taking some profit over the years is a good idea. It is like inching towards the fire exit.
Are you ready to be a Connoisseur?
It takes a lot of nerves and patience to be a Connoisseur. It is something everyone should aspire to.
The best investors all benefited from holding a few massive winners. Strip out these big winners and their returns would be distinctly average.
The way to build long-term returns is through presevation of capital and home runs. Many managers, once they’re up 30 or 40 percent, will book their year…. The way to attain truly superior long-term returns is to grind it out until you’re 30 or 40 percent, and then if you have convictions, go for a 100 percent year.
Stanley Druckenmiller
Conclusion: The habits of success
The success enjoyed by top investors is not due to possessing a special gift, nor from having a privileged upbringing. Nor is it down to being born geniuses, though many were very smart. Instead, any success ultimately came down to just one thing: execution. They know what to do when they found themselves in a losing situation and likewise what to do when they found themselves in a winning situation.
- If they were losing, they knew they had to materially adapt, like a poke player being dealt a poor hand. They had each independently developed a habit of significantly reducing or materially buying more shares when they are losing.
- When winning, to take an analogy from baseball, the successful investors know they had to try to hit a home run, as opposed to stealing first base.
Successful investors want you to think that success in investing is beyond the abilities of the average person. They want you to believe that returns are driven by managers and teams possessing special gifts.
Success in investing is open to anyone. You simply need to materially adapt when losing and remain faithful when winning.
Lots of people know what to do, but few people actually do what they know. Knowing is not enough! you must take action.
Tony Robinson
The Winner’s Checklist: The five winning habits of investment titans
- Best ideas only: Invest in just a handful of your very best ideas
- Position size matters: Be prepared to invest big – just do not go all in on day one
- Be greedy when winning: Run your winners
- Materially adapt when you are losing: Either add meaningfully to an existing investment or sell out
- Only invest in liquid stocks
The Loser’s Checklist: The five losing habits of most investors
- 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
* It depends on what you invest and your experience. Read: The great investing myth (5): Concentration versus diversification
