Warning: For serious investors only! PART 2

At the end of part 1 of this blog post we parted with the open question:

How were most of these investment legends able to be wrong more often than they were right and still make incredible profits?

To analyze the differences the author grouped those investment legends according to certain behaviors they displayed after the investments were made (entry is not as important as so many people try to make us believe), namely, when they were loosing and when they were winning.

A) They were loosing. What did they do?

The RABBITS were caught in capital impairment.  When they were losing they did nothing, which proved to be wrong in any potential future development.  Wrong, wrong, and wrong again.

The ASSASSINS sold losers quickly when the loss extended beyond a range of -20 to -33% per trade.  They stomached a much bigger loss than our regular stop loss of 8 to 12% which is often described in other literature.  They were fully aware and adhered to the insight that the execution of an idea is key and not being right per se (humility!).

The HUNTERS planned beforehand to buy more shares if a price fell (“dollar-cost-averaging”).  They were value investors with a clear contrarian style who bought when everyone else sold.  Another way of exploiting Mr. Market when he was acting irrationally.  However, they followed their plan only after a positive answer to the question: “Would I buy this knowing what I know now?”

Lessons learnt:  To make money we need to have money.  To maximize profits we have to minimize losses.  We must preserve our capital, because winning is all about ensuring the upside return potential is significantly greater than the downside potential loss.

Success often arises from what we do when we are losing.  We can get big decisions wrong and still make money provided we are willing to materially adapt.

B) They were winning.  What did they do?

The RAIDERS were right most of the time and still lost money.  They had high hit rates but poor payoff profiles.  They sold too soon because it felt good (addicted!).  They have not been able to “stand the pain of the gain” and got bored or frustrated.  They were not successful in fighting against our natural tendency for hyperbolic discounting, myopic loss aversion and recency bias.

You see, the famous Prospect Theory (by Twersky & Kahneman) states:

People are risk-averse when winning, hence they take profits – but risk-seeking 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.

Read the passage above once more, please.  Does that sound reasonable to you?

Lessons learnt: We shouldn’t sell early because stock market returns over time show kurtosis, which means fat tails are larger than would be expected from a normal distribution curve.  If we are not invested in those big winners our returns are drastically reduced.

Extremes dominate our world and we think they are abnormal.

And finally there were the CONNOISSEURS with a lot of nerves and patience.  They held a few massive winners for long time frames.  Strip out those big winners and their returns would be distinctly average.

Which of the above 5 distinct styles describes you best?

Are you a crossbreed between an ASSASSIN and a CONNOISSEUR?

Whatever style you employ, it is important to know your character, know your environment and your investment “horse”.  Once you have the discipline to stick with your style and are prepared to lose to win you are ready for those high returns that are built through preservation of capital and home runs.

In conclusion I am convinced that you the serious investor will not be surprised by anything in this book.  Yet your performance could be vastly improved if you followed the advice extracted from those investment legends.

Once again simple, but not easy.