Thursday, August 18, 2016

Let your winners ride and your losers wither

Psychology plays a major role in investing. Having a solid mastery of your own psychology can help make you a better investor.
I was reading an article recently which delved deeply into the psychology of investing. The articles basic premise was that investors have a much greater aversion to the same magnitude of the loss then they do to a similar corresponding win.
The implications of this is that we are much more likely to take profits too soon on extraordinarily good investments and to let dogs linger too long, with the hope that we will eventually recover our money.
More often than not, the dog is a dog for a reason, and just continues to have deteriorating performance. I think key is to be able to distinguish a dog that has structural problems from one that is just stuck in a cyclical rut.
This has some interesting implications and investment strategy. Investment success and the returns that your investments have are very much distributed on a bell curve.
That is you don’t get an equal proportion of companies which achieve long-term returns of 5%, 10%, 20%, etc. rather relatively few companies achieve astounding long-term success and many more companies achieve average investment success.
This principle brought to mind parallels that occur in venture investing. In venture investment it’s relatively few companies that deliver homerun returns for their investors. For every Facebook, the venture landscape is littered with hundreds of companies that just don’t make the journey. While this type of bell curve distribution isn’t as pronounced in the public marketplace given the relative maturity of these companies a similar pattern of distribution is likely observable.
You’ll only get a relative handful of companies that achieve returns like MasterCard, Facebook and Amazon and Google. As such when you successfully identified these businesses, it’s important that you hang on and selectively monitor them long term. Getting off the train to early will likely cheat your portfolio of much-needed alpha and make it more likely you will achieve mean reverting returns.
When someone is in too much of a hurry to take profits they actually effectively negatively handicap their likely ability to achieve long-term investment success. What they’re effectively doing is removing from their investment portfolio the better prospects to substantially outperform. Also by hanging onto the dogs too long they are making it more likely that they will effectively underperform or achieve a return that’s closest to the mean.
This made me think about the way that mutual funds work. The constant rebalancing that they’re forced to do to stay within other sector limits or to maintain position weighting  makes it all the more likely that they will be mean reverting.
That is, over the long term they will struggle to outperform low-cost index benchmarks. Similarly if you as an investor maintain an active policy of rebalancing or selling your winners too soon you will also achieve similar results.
The long-term keys to investment success are less about your ability to pick a majority of stocks with positive returns but rather your ability to find fewer stocks with massive long-term returns.
While this sounds relatively simpl,e the implications from this quite profound. It suggests less of a focus on having a large number of stocks and more of a focus on selectively doubling down on those gems in your portfolio that achieve good success. It also suggests that buy-and-hold in the right long-term picks should lead to massive wealth and that deliberate, selective concentration is also the right long-term strategy
 This article was written by Financially Integrated. If you enjoyed this article, please consider subscribing to my feed.

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