Outliers and Distinction

Part two of a two-part reflection on Lee Freeman-Shor’s The Art of Execution. Read Part 1 here

In part one, I wrote about Illusion, the idea that more data doesn’t necessarily lead to better decisions. The lesson was that we often respond to how risk presents itself, not to the risk itself. Here, I want to turn from how returns feel to how they actually arrive.

Outliers

Most individual stocks are bad investments

That is not pessimism. It is arithmetic. J.P. Morgan’s Michael Cembalest has, for years, maintained a study “The Agony & The Ecstasy.” In the 2014 edition[1], they found that 40% of the stocks in the Russell 3000 had absolute negative returns — you lose money holding them over the long term — and that the median stock actually performed worse than the market.

So where did all the market’s wealth come from? From a tiny minority. Only around 10% turned out to be what the study calls “megawinners” — and that small handful generated the enormous gains that more than made up for the loss makers. The pattern held broadly across sectors, though some deviated more than others.

Market returns are not normally distributed[2]. They are not a tidy bell curve clustered around an average. They are fat-tailed and heavily skewed — a great mass of disappointments and quiet losses, with a few extraordinary outliers doing most of the work. The average return of the market is not the experience of the average stock. The market return is simply what you get when the few extraordinary winners are blended with the great number of losers.

This is exactly what Freeman-Shor found inside his own data. His investors were wrong more often than they were right. What saved them was that, on their best ideas, they let the winners run — and on their worst, they cut the losses before they became fatal. They won big and lost small. The shape of their returns mattered far more than the frequency of being correct.

What can we do

If the winners are few, scattered, and almost impossible to identify in advance, then there are only two honest strategies.

The first is to be very diversified — to own so much of the market that you are guaranteed to hold the few megawinners, whoever they turn out to be. You will own the losers too. But remember; the winners more than compensate. This is the philosophy I build my clients’ portfolios on: holding thousands of companies across nearly every country, so that we never have to be the genius who picked the one that truly wins, or the fool who picks the ones that fail.

The alternative is to be genuinely, deliberately concentrated — to select carefully your “ten best ideas” and to accept the volatility that comes with that. This is a hard road, and an unforgiving one. A mistake could lead to a “permanent impairment of capital”[3]. And don’t forget, the more data you have, the more confident — not necessarily more accurate — you become.

Living in the muddled middle is probably the worst place to be.

What you shouldn’t do is live in the muddled middle: holding a hundred or so stocks you picked on half-conviction. That gives you the worst of both. You are more likely to miss the winners and, probably, hold the losers. Either own everything, or know precisely why you own the few things you do (and what to do with them). The space in between is where most quiet damage is done.

Distinction

Where I disagree with the book

I write this with respect — the author is a formidable thinker, and disagreement is not dismissal. But there is one idea, touched on in the discussion around diversification, that I think is worth challenging — getting it wrong is costly.

The argument he makes is that by diversifying, you are not really removing risk, you are merely swapping one kind of risk for another — trading unsystematic risk of individual companies for the systematic risk of the market as a whole.

This is not quite right, and the distinction is important. There are two kinds of risk in a portfolio. The first is unsystematic risk — the risk specific to one company or one sector. A scandal, a failed product, a missed quarter. The second is systematic risk — the risk that belongs to the entire market. A war, a financial crisis, a pandemic.

Here is the key point. When you diversify, you are not swapping one for the other. You are eliminating the first while keeping the second — the key word being “keeping.” You were always exposed to the second. Systematic risk affects every stock; it cannot be diversified away, no matter what you own.

Diversification does not trade unsystematic risk for systematic risk. It removes the unsystematic risk and leaves you holding only the market risk – the risk you could never have escaped in the first place. Diversification is the discipline of preventing a single event from wiping you out.

So what does all of this leave us with?

My biggest takeaway is that what makes a concentrated portfolio work is not that fund managers could predict the future – no one can. It works because the fund managers build strategies that did not depend on being right; it works because the strategies were built to respond to what the market did, and adjusted rather than clung on.

The market rewards people over time; even in this book, time IN the market was the key. And our natural behaviour destroys yields. Our strategies must survive us being humans. Success comes to those who understands their own limits and builds a plan that holds up anyway.

Time IN the market wins

The ideas were never the hard part. They never are. It was always the execution.

And for me, that is why I still prefer to be diversified. Because I know, when it comes down to the execution, the decision is never as rational as we’d like. And when it comes to money, the heart strings are tugged even more.

Stay diversified. Stay patient. And be a little suspicious of how certain you feel.

In part one, I share about the illusion of data.

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I write on topics related to financial habits and decisions. Do explore my other articles at https://www.williamseah.com/blog if the ideas resonate. Drop me an email at reach.william@gmail.com or text me at 9673 1523 if you'd like to chat over coffee or whisky.

References

Freeman-Shor, L. (2015). The Art of Execution: How the world’s best investors get it wrong and still make millions. Harriman House.

Cembalest, M. J.P. Morgan. “The Agony & The Ecstasy: The Risks and Rewards of a Concentrated Stock Position.” (Figures cited from the 2014 edition: Russell 3000, 1980–2014.)

[1]https://www.chase.com/content/dam/privatebanking/en/mobile/documents/eotm/eotm_2014_09_02_agonyescstasy.pdf  The other editions of the same document are available on various websites. Let me know if you want the editions.

[2]Nassim Taleb might call it Extremistan, where one event can dominate others.

[3]The Art of Execution, Freeman-Shor, Lee. In the chapter, It’s All About Capital Impairment.