Buy the Book: Freeman-Shor studied over 1,800 investments made by fund managers under his leadership to see if there were similar habits that led to their success or failure. He shares the common habits found around losing and winning investments that improve and hurt returns.
The Notes
- Money management is key to successful investing: how much money is allocated to a position and what you do with a winning or losing position.
- Study Results
- The author studied 1,866 investments, totaling 30,784 trades, made from 2006 to 2013 by 45 fund managers under his leadership. Trades were made for a Best Ideas fund limited to 10 stocks per manager. He then categorized managers into groups based on similar tendencies when dealing with winning investments and losing investments.
- Only 49% (920) of the investments made money. Some managers had a success rate as low as 30%. Yet, almost all managers made money overall.
- Out of 941 investments that lost money, only 3% (32) made money because additional trades were made after the initial investment. They bought more at a lower price, lowered their overall cost basis, and made a profit once the price recovered. Many more losing investments could have been profitable if the investors adapted and bought more at lower prices.
- Out of all losing investments, 2% (19) lost more than 80% and 14% (141) 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.
- Only 11% (101) of winning stocks gained more than 50%. Only 1% (21) returned more than 100%. Strict reliance on price targets and selling after a small profit is the leading reason why there were so few big winners. They failed to let the winners run.
- 59% (557) of the losing investments made money after they were sold. So 41% (389) saw a further decline in price. But of the 557 losers, 37% (205) returned less than 20% after the sale.
- 64% of losing investments were sold within 6 months, 42% were sold within 3 months, 17% were sold after one year.
- Of all the investments, 22% (421) realized a loss of up to 10%. 59% (249) of those made money after the sale.
- 66% (611) of winning investments were sold for a 20% profit or less. Of those, 61% (370) rose after it was sold. Investors sold too early and missed out on further gains. The most successful investors all had at least one big winner in their portfolio.
- 42% of profits were taken within 3 months of purchase. 61% of profits were taken within 6 months of initial purchase. Only 2% of profits were taken after three years. It’s hard to hold on to winners.
- Only 1% (21) of investments returned over 100%.
- 68% of the time managers sold for a profit if a stock outperformed the benchmark by up to 23%.
- Losing Investments
- The author broke down the managers into three categories — Rabbits, Assassins, and Hunters — based on how they handled losing investments.
- Rabbits – Failed to avoid massive losses. Returns suffered for it.
- What not to do!
- Typically bought a stock and did nothing with it (or added to the position at lower prices) only to finally sell after a loss of 50% or worse.
- A 99% loss needs a 9,900% gain to break even. The goal: avoid massive losses!
- Mistakes:
- Illiquidity risk: if it’s hard to build a position due to lack of volume, it’s harder to unwind a position for the same reason.
- Some claimed the stock was still a great company, despite the losses, but their actions failed to back it up. Instead of adding to the position at a lower price, they did nothing as it fell.
- Framing Bias – decision-making is affected by how a problem is framed. When combined with the narrative fallacy, the fund managers would reframe the story so their investment thesis and time frame was intact. Any information that negatively impacted the company was automatically dismissed.
- Primacy Error – the first piece of information has an outsized impact compared to any new pieces of information. First impressions are everything. It’s why the direction of a stock’s prices impacts whether investors view a stock as good or bad over the foreseeable future.
- Anchoring – relying too much on the first piece of information we’re given on a topic. Investors tie themselves to the price paid for a stock or valuation model and are slow to update based on new information.
- Endowment Bias – we peceive things we own to be worth more than the going market rate.
- Large losses over a short time period can be hard to accept — “It’ll bounce back.” It’s easier to rationalize a reason to hold on than suffer the pain of locking in the loss.
- Peer Pressure (Herding) – it’s easier to conform than invest on an island. It’s easier to be wrong when everyone else is also wrong.
- Being right was more important than making money.
- Self-Attribution Bias – we attribute success to skill and failure due to external factors beyond our control. It’s hard to learn from failure if it’s always blamed on someone/thing else.
- Waiting for “More Information” – studies show that more information often increases confidence without increasing accurate decision-making. The waiting only stalls the inevitable sell decision and leads to a bigger loss.
- Denomination Effect – it’s easier to spend small denomination bills compared to large bills. It’s easier for investors to let go of small-dollar losses versus large-dollar losses, especially relative to the size of the portfolio.
- Gambler’s Fallacy – The incorrect belief that the odds of a random independent event improve because there was a string of losses.
- Ambiguity Aversion – favor the known over the unknown. It’s easier to hold onto a losing position because the alternative may be worse.
- Solutions:
- Have a plan beforehand. Know exactly what you’re going to do if the investment rises or falls x%. Then follow through.
- Always ask: would I buy the stock today, knowing what I know now? Sell if the answer is no.
- Better to get out too early than too late. In Being Right or Making Money, most investors’ realized losses in the final third of a bear market’s decline. They sold near the bottom.
- Seek opposing views on investments. Look for reasons to be wrong. If you can’t find any, great.
- Stay humble. Better to expect to be wrong, unlucky, etc. sometimes than overconfident.
- Avoid sharing positions publicly. It’s often harder to sell without looking bad.
- Find the downside of every investment first. It’s easy to look at the upside first and let it outweigh the odds of a loss occurring.
- Preservation of capital: A risk-first approach is key to minimizing losses. You can’t invest if you lose it all.
- “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.”
- Assassins – Had the discipline to quickly sell losers.
- Had two preset rules created in advance that dictated what they did with losing investments.
- Two rules:
- Sell at a preset loss percentage – most managers’ preset sell rule fell in the 20% to 33% range. Some set stop losses at the time of purchase.
- Sell after a preset time – 6 months was the average preset time period they sold losing stocks if the price was stagnant and/or showed no sign of recovery.
- Rules remove emotion from the decision-making process but also from overreacting to early losses of only 5-10%.
- Mistakes:
- Break-Even Effect – after a loss, opportunities that offer a chance to make your losses back look more attractive than reality. Investors that realize a loss tend to take riskier bets to get back to even quicker and are more likely to compound the losses.
- Every sale involves two decisions:
- The decision to sell.
- The decision where to invest the proceeds next — where mistakes can be compounded. Cash is often a better option than a low-conviction investment.
- Disposition Effect – the tendency to sell winners and hold onto losers. Frazzini found that the highest returns were earned by investors that sold out of losing positions the most.
- Hunters – Added to high-conviction investments at lower prices, lowering their average cost, and made money after the stock recovered.
- The value investors – added to positions if it passed the “Would I buy this today?” test.
- They had a preset plan to average into an investment. If the price never falls, they had only a small position. But if the price did fall, they loaded up into a large position.
- Many added to a position after a 20% to 33% decline in price.
- Used a preset formula for new position:
- 1/3 of the amount for the initial position.
- 1/3 of the amount if the price fell to a certain limit.
- 1/3 if it fell further.
- Requires:
- Being comfortable with early losses.
- Being comfortable buying a falling stock.
- Being comfortable with 40% of a portfolio in a single position.
- Being patient and disciplined with the purchases and sales.
- Mistakes:
- The biggest mistake was failing to buy more shares at significantly lower prices despite still being a “great company.” If it’s so “great,” load up on shares. Or maybe it’s not that great.
- Failed to account for the possibility of a lower price and/or had no funds to buy more shares.
- Career risk — the pressure of looking bad by adding to a losing position was too high so they did nothing.
- Winning Investments
- The author broke down the managers into two categories — Raiders and Connoisseurs — based on how they handled winning investments.
- Raiders – failed to let the winners run.
-
- What not to do!
- Consistently sold positions too early for a small profit. Selling early meant missing out on larger gains. But also meant having to find another investment or sitting unproductively in cash.
- Often have a high success rate but fail to make money because the gains are too small and wiped out by a single, unexpected large loss.
- Mistakes:
- It feels good to take a profit — dopamine rush.
- Impatience – tired of waiting, price inaction, boredom, need to do something.
- Myopic Loss Aversion – creates a negative reaction to short-term losses often at the expense of long-term gains. Investors sell winners out of fear of short-term reversal or losses.
- Tend to hold a short-term time frame on most investments.
- Risk Aversion – people are more risk averse when winning, and more risk takers when losing.
- “When losing, 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.”
- Overconfidence – in the ability to find another winner or take an unnecessary risk because you’re “playing with the house’s money.”
- Career Risk – a little relative outperformance is better than the risk of underperformance.
- The worst combination was cutting winners and running losers.
- “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.”
- Momentum Factor – has shown that winning stocks continue to win.
- Having a system or rules that prevent you from selling winners early can significantly improve overall returns.
- Connoisseurs – Let the winners run.
- Typically had a lower success rate — made money in 4 out of every 10 investments, on average. But their winners won big and made enough to cover the losers and more.
- Had a process that helped them embrace winning positions. Also were either quick to sell losers or comfortable adding to positions at lower prices that later became winners.
- Gradually trimmed winning positions by taking small profits over time.
- Requires:
- Companies with a lot of upside worth holding on to for 10+ years.
- Quality companies, predictable earnings growth, cash cows, with a low chance of negative surprises.
- Not trading at high valuations at the time of purchase.
- Built large concentrated positions.
- High boredom threshold.
- Best Ideas Paper (source)
- Best ideas were determined by position size. Highest conviction = largest position size.
- Managers’ highest conviction stocks outperformed other stocks in the portfolio and the market by 4 to 16% per year.
- Managers’ top 5 stocks also outperformed the market and the rest of the stocks in the portfolio.
- The best ideas significantly beat the worst ideas.
- Very little overlap between managers studied. Over 70% of the best ideas did not overlap across managers.
- “What if each mutual fund manager had only to pick a few stocks, their best ideas?… We document strong evidence that they could, as the best ideas of active managers generate up to an order of magnitude more alpha than their portfolio as a whole.”
- “The poor overall performance of mutual fund managers in the past is not due to a lack of stock-picking ability, but rather to institutional factors that encourage them to over diversify, i.e. pick more stocks than their best alpha-generating ideas.”
- “The secrets of successful execution were really just a matter of habit.”
- “In the world of investments, there is no such thing as a safe bet. If you invest in a company and think that it is bulletproof, I urge you to have an action plan to decide what to do when things go wrong – things often do.”
