There are two money managers that have been in the business for over a decade. You are looking to hire one of them. John, runs a decent-sized hedge fund where he has made a total of 10 equally-weighted investments over the past year. Of those 10 investments, only 2 did not go his way. With his 80% success rate, John seems to have the ability to deliver excellent odds for moving your portfolio forward.
Jane, on the other hand, runs a small advisory firm. Jane made a total of 8 equally-weighted investments over the past year. Of those 8 investments, 4 of them did not go her way. With only a 50% success rate, Jane does not seem to offer any more value than a monkey throwing darts, right?
So who is the better money manager? Well, it depends.
In the example below, John only had 2 losing trades, but they were doozies. By letting just a couple of his investments get away from him, John’s overall performance was drastically affected. Jane, on the other hand, was far less successful than John at being able to pick winners; however, unlike John, she did not let any of her investments get away from her. When Jane was wrong on her selections, she sold them for small losses before they could negatively affect the larger portfolio. By doing so, she was able to significantly outperform John, even with a 50% success rate.
The main lesson here is that avoiding the big loss is the key to overall performance. The best money managers understand that, when they are wrong, they must make certain they are only a little bit wrong. You cannot afford to be married to any of your positions. Pride, ego, product devotion, taxes, media hype – these are just excuses. Jane sees the big picture; John does not.
John may actually be bona fide genius. In fact, his reasons for initially choosing the two big losers above may have been nothing short of brilliant… so much so, that only an idiot would fail to see his logic. Unfortunately for John (and every investor), the stock market does not have to behave logically. Even a “guru” like John needs a discipline for selling.
Investors like Jane realize that the only bad investments are the ones you let get away from you. Establishing unemotional plans to limit your losses are just as important as the research you do to choose your investments.
Gary Gordon is president of Pacific Park Financial, Inc.