The Art of Execution is an eye-opening book written by Lee Freeman-Shor. For those who’re interested to learn about investing, the book unfortunately doesn’t teach the reader about how to pick stocks nor how to do fundamental analysis nor technical analysis. However, the book does help the reader to discover the concept of money management.
Very often beginner investors are fixated so much with doing the fundamental analysis, looking at the financial ratio, analyzing the company prospect, calculating the right entry price. But subsequently when faced with a losing position after purchasing their investment, they just simply don’t know what to do. As Mike Tyson said, “Everyone has a plan ’till they get punched in the mouth.”
The book starts by the author introducing that he has given 45 of the world’s top investors amount of money to invest in their top ten ideas. Shockingly he found that only 49% of the investments made money. And even more shockingly these legendary investors were only successful 30% of the time. However, despite some of them only makes money on one out of three investments, almost all of them did not lose money. When in fact, they made a lot of it. This leads to the topic of the book: how did these investors execute their investments?
In the investing world, there are only two positions: when you are winning, and when you are losing. Very often, retail investors like most of us are stunned with dilemmatic options on what to do. When winning, they are too excited to take that 10% profit off the table. When losing, they are afraid to cut loss and move on.
The book shares with the reader on three types of characters when investors are faced with losing position: the Rabbits, the Assassins, and the Hunters. The Rabbits are basically those who do NOTHING when faced with losing position – neither they sell neither they buy. The Rabbits could have done differently by executing the following:
- Always have a plan… know what to do when the stock you’re investing falls or rises by 20%, 50% etc
- Sell or buy more… the only solution to a losing position is to sell out or significantly increase your stake
- Don’t go all in… always keep some powder dry
- Don’t be hasty to jump in, but DO be hasty to jump out… what separates the winner from losers? The winners make small mistakes, while the losers make big mistakes
- Seek out opposition … speak to someone with an opposing view to mitigate emotional attachment of a vested interest
- Be humble … expect that your ideas may be wrong & invest with that in mind
- Keep quiet and carry on
On the other side, Assassins choose to kill losses early by implementing stop loss. The first rule is assassins will kill all losers at 20-33%, knowing that a loss of 33% will require a 50% subsequent return to break even. As the author found out, that only 11% of the winning stocks produced realized return of more than 50%. And only 1% realized return more than 100%. Assassins also choose to kill losers after a fixed amount of time. As the old axiom says: “Time is money.” Assassins fully understand the concept of opportunity cost. And the assassins’ second rule is basically to sell stocks which went down by any amount and showed no signs of recovery after a certain period of time. Majority of the assassins drew the line at six months. However the data shows that 99% of all bad buys were sold within three years.
As opposed to the assassins, Hunters will usually wait a little longer & double down by adding position. Unlike assassins, Hunters did not sell out the losing positions – they buy significantly more shares.Then they sat back and waited for it to recover, eventually selling it for a handsome profit. This is similar to doubling down in gambling. But in well chosen investments, this strategy wins over time. Always invest a lesser amount at the outset and keep some cash on the side – wait for opportunity to buy more at lower price in the future. Hunters are very often contrarian and value investors.
On the second part of the book, the author discussed the scenario when investors are winning. There are two characters here: the Raiders and the Connoisseurs. The author started by providing the data that one of his investors had an incredible success rate – 70% of his ideas were correct but didn’t make any money. It appeared that whenever this investor made a small gain of 10% he would immediately sell the stock and take the profit. The authors also emphasizes how detrimental it is for a manager to take profit when stock was up by 20% or less. 66% of all winning investments were sold at profit less than 20%. Out of these, 61% kept going up and had the investors stuck with them, he would have made more money.
There are few reasons why investors choose to sell too soon (i.e. becoming Raiders):
- It feels so good… selling for a profit is a nice feeling
- Boredom… getting tired of waiting for action
- Fear … Investors think they are getting rid of weak winners and replacing them with stronger ones, but in fact it’s the opposite.
- Short-termism… too focused on the short term
- Risk aversion… when winning, selling is appealing because the certainty of a small victory is better than the uncertainty of a loss or greater victory. When losing, risk is appealing because anything is better than a certain loss.
Finally, come the Connoisseurs. These are the most successful investors discovered by the author. Connoisseurs do the following that lead to their successes:
- Find unsurprising companies … identify companies with a view to holding them for ten or more years
- Look for big upside potential … given that the average success of an investment idea is 49%, need to make sure that when you win, you win big.
- Invest big – and focused… when Connoisseurs were very confident in an idea, they built up big positions. They could end up with 50% of their total assets invested in just two stocks. The author suggested to invest only up to 25% of the money in a single idea. There is no use having a small investment in a big winner – you have to have a large position size to generate big returns.
- Don’t be scared … Most people are scared to ride a big winner. One way to avoid this is by taking a small profits as the stock kept going up rather than selling entirely out of the position having made 20% or 50%.
- Make sure you have a pillow … must have a high boredom threshold. This is difficult because most of us feel the need to always do something every day.
In summary, the author also reiterated that it takes a lot of nerves and patience to be a Connoisseur. As Stanley Druckenmiller famously said, “The way to build long term returns is through preservation of capital and home runs.”