Being a fan of a losing sports team can be painful (Jets fans anyone?). But as sports fan, we are not risking our financial future from a continued support of the team. However, continuing to support a losing portfolio of companies in the face of a shifting market dynamic, can be a recipe for sustained underperformance.
It’s no use having a high conviction in your stock picks but get them spectacularly wrong. Conviction should be a measure of the skill of the investment team and this is not measured by how many stocks you own, but by the consistency and persistence of beating the benchmark.
High conviction investing strategies sometimes call for the unwavering support of a portfolio of companies in the face of a shift in market sentiment. High conviction strategies have the potential to perform incredibly well but also may lead to financial ruin if poorly timed or executed.
A potential negative effect from experiencing success in investing is the tendency to overestimate one’s level of skill. This may cause the investor to push further out on the risk spectrum where they get burned by an unanticipated shift in the market’s appetite for risk.
The more successful you are at something, the more convinced you become that you’re doing it right. The more convinced you are that you’re doing it right, the less open you are to change. The less open you are to change, the more likely you are to tripping in a world that changes all the time.
The best performing strategy in one calendar year, often performs remarkably poorly in the next. Case in point, the Ark Innovation ETF (ARKK).
Morningstar.com
Source: Morningstar ARKK Performance
ARKK was the best performing ETF in 2020 with an incredible 156.9% return. Turn the page a year later however, and it was one of the worst performing ETFs with a -23.6% return for the year. This provides a glimpse of the downsides for maintaining one’s high conviction strategy in the face of a changing market environment. 2022 has not looked much better for ARKK as the fund is already down over 10% YTD.
morningstar.com
Source: Morningstar
One sure-fire way to underperform one’s benchmark, is to concentrate the portfolio on its money-losing positions. However, high conviction investing may sometimes call for a healthy dose of profit taking. Ark selling its highest conviction stock Tesla (TSLA) was an example of prudent portfolio management.
Unfortunately, Ark decided to pile this cash back into more of its unprofitable growth companies, effectively doubling down on a losing investment strategy. This has provided little safe haven during the risk-off market environment we are in. Maintaining conviction in one’s strategy can be difficult, especially in the face of severe losses. However, it will become even more challenging when balance in the portfolio is actively disregarded.
The Value of Maintaining Realistic Expectations
Hope itself should not be relied upon as an investing strategy. Arbitrarily falling in love with the stocks we own can prove detrimental to our long term returns. Selecting individual companies for investment requires a great deal of commitment, however that does not mean that we should increase our position size indiscriminately of the situation.
Hope is the belief in the possibility of a positive outcome, even though there is some evidence to the contrary. In spite of continuing bad news, investors will steadfastly hold onto their losing stocks, based only on the faint hope that they will at least return to the purchase price. The decision to hold is not based on rational analysis or a well-thought-out investment strategy, and, unfortunately, wishing and hoping a stock will go up does not make it happen.
This is especially true for newly public companies with potentially unproven business models. Stock markets indexes won’t always go up, and it is therefore useful for investors to have a strategy to protect themselves on the downside. Maintaining strong conviction in our investments is important, but by no means does it improve our chances of success.
In the late 1990s, spurred on by the potential of the Internet, hundreds of tiny companies sprung into being, determined to disrupt industries and find profit in doing so. A decade later, almost all of them were gone. Many of the famous failures – Pets.com (pet supplies), Boo.com (fashion), and Beenz (digital currency) – now seem to be just a bit ahead of their time, as many of their products have become successes in the modern world.
Investors cite examples of companies suffering drawdowns which ultimately recovered as their excuse for concentrating a portfolio on money losing businesses. Amazon, (AMZN) one of the most commonly cited examples of this, is the exception rather than a rule we should live by.
According to a study by J.P. Morgan, 40% of all stocks experience a catastrophic decline from which they never recover.
A problem with focusing on these types of examples is that they are highly unlikely to occur, especially at a level of magnitude that Amazon was able to achieve. Winning companies will eventually recover, rewarding its investors for maintaining conviction, but a significant portion of companies will never reclaim their old highs.
Picking the wrong stock during a period of marked underperformance has been a proven recipe for poor long term returns. Ironically this insight was shared in March of 2020; one of the most ideal times to employ a knife catching investing strategy.
Predicting the direction of stock markets in the short term is clearly a challenging task. However, if one chooses to maintain a high conviction investing strategy, they better be sure that they are picking the right companies to invest in during periods of market turmoil.
Stock Markets Go Up, But Can Sometimes Take Decades To Reach New Highs
morningstar.com
Source: Morningstar
Over the long term, stock markets travel in just one direction, upwards. There are however, periods of market weakness that will test an investor’s conviction. I therefore believe it is valuable for investors to have a game plan for when a favored investment strategy is no longer in style.
Employing a balanced portfolio with a mix of assets that do well in all market environments will better enable you to stay the course. Conviction is always important in investing, but without sufficient balance in the portfolio, concentrated investment strategies will become more difficult to implement.
The reality is that only a small subset of stocks will drive the majority of a stock market’s gains. This is the reason that index investing has become such a popular strategy over the years. If one chooses to concentrate their portfolio on just a small subset of stocks, they need to be prepared for the wide set of outcomes that may result.
Conclusion
With 40% of stocks experiencing catastrophic failure, it is inevitable that investors will pick losing stocks at some point. Learning to dispose of one’s losing positions is a valuable tool for investors. Experiencing losses in a portfolio often provides great feedback which can improve upon one’s investing strategy. Fighting our inherent biases and cutting losing positions can be a tough pill to swallow, but it is an attribute shared by many of the world’s greatest investors.
Stock markets have a way of humbling us when we least expect it. By concentrating a portfolio on losing positions, there is potential for our long-term returns to suffer. Maintaining conviction in one’s stocks can be a difficult task especially in the face of severe losses. A commitment to preserving balance in one’s portfolio will make this a less daunting task.
