Over seven years, 45 of the world’s top investors were given between $25 and $150m to invest by fund manager Lee Freeman-Shor. His instructions were simple. There was only one rule. They could only invest in their ten best ideas to make money.
The process gave Lee the perfect position to view what investment strategies succeeded and failed and even more importantly how some of the top investors played the market conditions they were dealt. In his book (The Art of Execution: How the world’s best investors get it wrong and still make millions in the markets) he outlines what he learned. The title of his book really does say it all.
Over a period of seven years between 2006 and 2013 Lee examined 1,866 of the very best investment ideas. He found that only 49% of these very best ideas made money, while some of the most legendary of investors only made money 30% of the time. In order to profit then it’s all about the execution, and that’s where this book is so important.
The book is split into two. The first part is called ‘I’m Losing – What Should I Do?’. Lee details the actions of three types of investors – Rabbit’s, Assassins and Hunters. The second part of the book is called ‘I’m Winning – What Should I Do?’. Here Lee describes the most successful investors as Connoisseur’s.
According to Lee investors fail to deliver the returns they could generate because they fail to back their winners with sufficient share of their portfolio. Instead they tend to think there is safety in diversification, when in reality they are better off concentrating their portfolio.
Firstly, many professional investors over-diversify when they invest because they are managing their career risk. Most are judged by their bosses and employers based on how they perform against an index or peer group over a short period of time. This militates against concentrating investments in potential long-term winners.
Secondly, regulators – based on investment theories from the 1970s – have put into place rules that prohibit professional fund managers from holding large positions in just a handful of their very best money-making ideas.
According to Lee many investors believe 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 (idiosyncratic risk), which may be very low depending on the type of company you invest in, for market risk (systematic risk).
Risk hasn’t been reduced, it has been transferred.
This is something that individual private investors can take advantage of. By concentrating in a small set of companies or sectors you can potentially gain greater insights than professional investors while also generating greater returns, unencumbered by how your peers see you or the eagle eye of the regulators.
Have a plan so that you never lose money
“Rule No. 1 – Never lose money. Rule No.2 – Never forget rule No.1.” – Warren Buffet
Another group of investors working for Lee were described as Assassins. These investors understood more than anyone that drawdowns left to fester destroy wealth. What matters is ensuring that the upside potential is significantly greater than the downside potential loss.
The Assassins are the investors who really lived and breathed this principle while working for me. 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 like nothing had happened.
Lee’s data showed that of the 946 investments that lost money, just 2% of them lost more than 80% while 14% lost more than 40%. The majority of investors Lee worked with understood that it doesn’t take too many bad decisions to destroy wealth.
The Assassins golden rules were:
- Kill all losers at 20-33%: The investors planned in advance through the use of stop-loss. Commonly used in trading, for some reason it is used much less frequently in investing.
- Kill all losers after a fixed amount of time: The longer you are in a losing position, the harder it becomes to catch-up with the lost compounding years. Based on the investors Lee followed two-thirds got out of losing positions within six months, while 99% were out within three years.
The philosophy of the Assassins was summed up by this quote from Jesse Livermore, “If it feels like a struggle then you should get out.”
The second part of the book is called ‘I’m Winning – What Should I Do?’. Here Lee describes the most successful investors as Connoisseur’s. The four main attributes of the Connoisseur’s were:
- Find unsurprising companies: Buy companies with a view to holding them for 10 of more years. More than that they bought companies that had a low probability of negative surprises, i.e. even if the company was run by terrible management ever it would still generate returns.
- Find asymmetry: According to Lee where many investors go wrong is that they invest in far too many ideas with limited upside potential (10-30%) and only focus on investments with very good upside potential.
- Invest big and focused: When the best investors were confident in an idea they built u big, concentrated bets. As Lee illustrates though, this can be very difficult for some investors to do. According to famed investor Stanley Druckenmiller, “When you have tremendous conviction on a trade, you have to go for the jugular. It takes courage to be a pig. It takes courage to ride a profit with huge leverage. As far as Soros is concerned, when you’re right on something, you can’t own enough.”
- Develop a high boredom threshold: It is very hard to focus on the handful of companies that you may be invested in without being drawn into new ideas. As Lee outlines, “Many of us, seeing we have made a profit of 40% in one of our stocks, start actively looking for another company to invest the money into – instead of leaving it invested. This is precisely why lots of investors never become very successful.”
The data backs up how hard this is to achieve. Only 11% of the winning investments made returns of more than 50%. Only 1% realised a return of more than 100%. Most investors banked their profits early, often forsaking supernormal returns as a result.
Lee uses the example of the Forbes rich list of the wealthiest people in America to make a great point that many of the richest people got to the top of the list through a great idea, opportune timing and perfect execution, but what really sets them apart is their low time preference. For example, it would have been so easy for many founders (think Steve Jobs or Mark Zuckerberg) to cash out of their companies. Instead, they rode the wave all the way to the top. “Resisting temptation and staying invested in a great idea is critical.”
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