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AAII Journal /
January 2016

 Read Comments (9)

Stock Strategies

Being Wrong and Still

Making Money
by
Lee Freeman-Shor
    

The investment ideas of the some of the greatest

investors on the planet today are wrong most of
the time, and yet they still make a lot of money.

How can this be? How can the world’s best

investors get it wrong and still make millions?

That was the question I faced several years ago

when I became rather obsessed with trying to
understand how one professional investor who
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worked for me was able to deliver outstanding
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returns when only one in three of his ideas made
money. I simply had to know what his secret was
that meant he could be so good (at making
money) despite being so bad (his investment
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ideas generally failed). I burned with curiosity, and
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this fire from within led me to analyze every
investment, every trade he did. The outcome of
this investigation was that I uncovered that he was
able to make a lot of money because of a few key
habits of execution that he religiously stuck to
when he found himself in either losing or winning
situations. In a nutshell, I discovered that when his
idea lost money he would turn into either a
“Hunter” or an “Assassin.” If he were winning, he
would become a “Connoisseur.”

Having made this discovery, a new question

surfaced: Is this finding true for all the successful
investors who worked for me? Basically, was their
success due to how they executed their ideas
rather than their ideas being successful overall?
To find out, I analyzed the investments of 45
investors I oversaw between 2006 and 2013, each
of whom I had entrusted with managing between
$20 million and $150 million dollars with strict
instructions that they were only allowed to invest in
their 10 best ideas to make money. After analyzing
30,874 trades that these professionals made
during the study period, I discovered that the
successful ones all adopted the same habits of
execution. The secret sauce behind their success
had been revealed.

Moreover, I discovered that the chance of a great

idea making money was a lousy 49%. Think about
this the next time some investment titan on TV
shares his “top investment tip.” Despite such ideas
often being the result of hundreds of hours of
research by some of the smartest people on the
planet, the chance of making money in these
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ideas is worse than tossing a coin and betting on
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heads. If success in property is about “location,
location, location,” I came to understand success
in the stock market came down to “execution,
execution, execution” of great ideas. Or, as
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attributed to the great inventor Thomas Edison,
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“Vision without execution is hallucination.”

The key to success depends upon the action an

investor takes when they find themselves in a
losing, or a winning, situation. Adopt the habits of
the successful investors and you too can find
yourself being wrong more often than you are right
and still making money.

I’m Losing. What Should I Do?

My findings suggest the odds are that an

investor’s great idea will lose money. As such,
before you invest a cent into an investment idea, it
is imperative to have a plan of action as to what
you will do if you find yourself in a losing position.

When losing, the successful investors I worked

with planned to become either Assassins or
Hunters. [Assassins sold losing investments that
fell by a certain percentage or that declined by any
amount and showed no signs of recovery after a
certain period of time. Hunters invested a lesser
amount at the outset and with a plan of buying
significantly more shares if the price fell. Hunters
were also unafraid to sell if it became clear that
they had made a mistake.] The bad investors
didn’t have a plan and consequently turned into
Rabbits. [When losing money, Rabbits neither
bought more shares nor sold their holdings. Once
forming an initial perception, Rabbits were
achingly slow to change their opinion of a stock.]
Which tribe will you become a member of?
If you want to be successful, you have to
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“materially adapt” when you are losing money. In
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reality, this either means cutting your losses and
taking the hit before you have lost too much
money (aka being an Assassin). Or, it means
backing up the truck and investing a lot more
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money into an idea (aka, being a Hunter). Clearly,
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if you want to be a Hunter you need to be careful
not to deploy too much of your capital in an idea
on day one because you have to be prepared to
invest significantly more money into the idea when
you are losing. This is a key difference from the
ordinary dollar cost averaging approach. It also
means that buying a few more shares doesn’t cut
the mustard. The key habit you are trying to
embrace is that of materially adapting when you
are losing.

Before you invest in an idea, you have to have a

predefined plan of action that will govern your
actions after the initial investment, and you have to
have the discipline to stick to it. Not having a plan,
or doing nothing (aka the Rabbits) or too little is a
character trait of a loser.
The problem with doing nothing is that it opens up
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the possibility of losing big. That is, you dig a hole
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so deep that you cannot get out of it (aka being a
Rabbit). My findings showed that of the 131 ideas
that lost more than 40% when they were sold, not
one would have bounced back to help the investor
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break even despite 21 of these going on to
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produce returns of over 100%.

I’m Winning. What Should I Do?

As with losing, you need to have a predefined plan

of action with respect to what you are going to do
when you find yourself having made a paper profit.
In this scenario, however, you will be given a
choice of joining one of two tribes: the
Connoisseurs or the Raiders. Your aim is to be a
Connoisseur. Raiders have a habit of taking profits
too early rather than letting their winners run.
[Raiders take profits as soon as practical.
Connoisseurs make high-conviction investments,
hold onto them for a long time and take small
profits along the way.]

My findings show that two-thirds of the time

investors will bank their profits when they have
made up to 20%. While it may feel good,
snatching at profits is a character trait (a habit) of
a loser. In fact, I discovered that 61% of
investments that were sold for a profit of less than
20% kept going up. Had the investor stayed
invested, they would have made more money.
Worse still, big winners were to be found among
those.

To be successful, you have to have one or two big

winners—not least because Sod’s law [Murphy’s
law in the U.S.] holds that you will have one or two
big losers. If your approach is to keep taking small
profits, you will never have a big winner. I have yet
to come across a successful investor whose
success was achieved without the presence of
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one or two big winners. The way a Connoisseur
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ensures he wins big is that he slowly nibbles away
at the growing pie of profits. He knows that to eat it
in one sitting will give him more problems than
merely an upset stomach. As hedge fund manager
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Stanley Druckenmiller once said, “[The] way to
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build long-term returns is through preservation of
capital and home runs.”

Summary

In conclusion, I have found that all successful

investors who have worked for me have common
habits that explain their success and ultimately
mean they can be wrong most of the time and still
make money.

Welcome to the American Association of

Individual Investors
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investment education.

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I have seen the enemy. It is made up of Rabbits

and Raiders. If you spot someone from one of
these tribes when you invest then know you might
face an unhappy ending.

Ensure you invest with the Hunters, the Assassins

and the Connoisseurs. Over time, these tribes will
look after you, keep you safe, and ensure you
prosper.
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Lee Freeman-Shor is a portfolio manager at Old Mutual Global

Investors, an asset management firm based in the United
Kingdom.

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Discussion
John Duguid from NJ posted over 5 years ago:

Interesting analysis. How does one distinguish a

rabbit from a connoisseur? Is it that the rabbit
thought his or herself as a connoisseur and had bad
judgment, whereas the connoisseur gets it right.
Hence the connoisseur is just a good stock picker
and the rabbit a poor one with the moral of the story
just to be a good stock picker? Or, as suggested in
the article, we can assume that we should accept
our 49% and if you find yourself a connoisseur going
down the rabbit hole, you need to become a hunter
or assassin until you can get back on the
connoisseur track? Stated another way, many value
investors have done well but there is always the
danger of getting caught in a value trap. Are you
proposing ways for the connoisseur to escape from
the value trap or implying that the connoisseur
knows how to avoid value traps altogether?

Stanley Hahn from CA posted over 5 years ago:

I HAVE 55 YEARS OF INVESTING EXPERIENCE.

DURING THOSE YEARS, I INVESTED BY MY
OWN STOCK PICKING AND WITH
PROFESSIONAL HELP.
I MADE JUST AS MUCH
AS THE PROFESSIONALS,THEY INCLUDED
BERNSTEIN,KEN FISHER AND MORE. WHEN
THE MARKET WAS UP THEY DID NICELY, WHEN
THE MARKET WAS DOWN SO WAS THEIR
 RESULTS.
I BELIEVE IN LONG TERM INVESTING,
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AS A RESULT MUTUAL FUNDS WAS A GOOD
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CHOICE. I BELIEVE DIVERSIFICATION IS
IMPORTANT, BUT SOME HOW I BUY TOO MANY
STOCKS AND CAN'T KEEP TRACK OF A GOOD
POINT TO SELL FOR A PROFIT. TRUTH BE SAID,
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I FIND IT HARD TO SELL, BUT VERY EASY TO
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BUY STOCKS.
THIS ARTICLE IN MY ESTIMATION
IS CORRECT IN EVERY ASPECT.

Martin Huber from CH posted over 5 years ago:

I think the best strategy is still to trade as little as

possible. Most studies show that the more an
investor trades, the worse is his performance. In
addition, he will lose a lot of time. Further, investors
are more likely to buy stock which will under-perform
in future and sell stocks which will outperform. Or
follow a very simple strategy: buy a portfolio of
stocks which performed the worst in the last 5 years
and keep these stocks for 5 years. Trading costs will
be very low. A UK study shows that the out-
performance is high, probably higher than the
performance of most professional money managers:
"More specifically we find that the 10 per cent of
shares with the worst total share return record over
five years go on to produce the highest returns in the
subsequent five years with an average out-
performance of 8.9% per year - defying those who
would write these companies off as the 'dogs' of the
market."
see
http://papers.ssrn.com/sol3/papers.cfm?
abstract_id=998418

John Wilson from Alberta posted over 5 years ago:

Two points:
1. The best strategy is to trade often but
small. Yes, paying more in commissions is fine when
your returns are high. In addition, the key to success
 is to take profits and let losers run. I know this goes
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against all conventional logic, but it works over time.
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Also, I sell puts and never buy stocks. It's much
more conservative. 2. The article is written by
someone who has money managers handling
institutional money. The average investor is not tied
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to just picking stocks like those guys are. We have
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the freedom to utilize other financial instruments
which can be more cinsrvative. I wish the author
would take that into confirmation. Letting winners run
is old school and is the only thing institutional
investors can do. Individual investors can do better
than that. I know. I was up 30.2% in 2015 on a 7
figure portfolio. This works.
John

Martin Huber from CH posted over 5 years ago:

You can probably beat the market in 1 or 2 years by

chance only - this is quite easy. But to beat the
market consistently over a long period of time is very
difficult. I think that a alpha of almost 9% (as
described above), with a strategy that needs no
effort, transaction costs and very little time, is an
excellent return.

David Levine from NC posted over 5 years ago:

I agree with the comments but rather than tell me

about a year's return I am more interested in either
the total return or annual geometric average return
over a decade or more.
After expenses, etc. I have
found it hard to beat the market's return over the last
decade. Over that period I am only 40 basis points
better than the market's annual return.
I could have
spent zero time on investing and done just as well if I
put my money in a Vanguard SP 500 ETF or mutual
fund.
I would be interested in other investor's
experience. This return is on a pure equity portfolio
 as I keep a separate fixed income portfolio for
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income and 100% preservation of capital.
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Roger Mckinney from OK posted over 5 years ago:

Joinadvice
The the 2,000,000+ individuals
is excellent whoterm
from a short have used AAII to advance their investing knowledge.
Membership
perspective. Starts
Longer at the
term, Only $2when investors
time
will hit home runs is right after a major crash, such
as 2009 and 2010 when the whole market rebounds
sharply. Similarly, the period when most ideas will go
wrong is just before a recession, like 2008. So if you
follow the business cycle closely you can skew the
winners and losers in your favor better than 49%

David Fields from TX posted over 5 years ago:

The advice is excellent. Success is having a plan to

get in and get out of equities. I follow a fixed set of
rules to invest and to get out. I would describe my
self as an assassin and a hunter. I am primarily a
growth investor in cash flow positive companies with
a PEG of 1 or less going in. Losses are limited to
25% on any issue.
During the past 10 years ending
12/31/2015 the S&P if compounded annually has
grown from a $10,000 investment to a value of
$16,400. I have managed to grow the same
investment to $33,300 following the fixed rules.

Eric Long from AL posted over 5 years ago:

Great advice. You are basically saying let your

winners run and cut your loses. I was a rabbit when I
first started out and had a couple of great ideas that
went all the way to zero. Since then I have found
stop loss orders to be a very good way of making the
sell decision.
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