Conviction, Confidence, and Courage – An Allegory

This is an outstanding paper written by two analysts at S&P Global – Anu Ganti & Craig Lazarra. Although the paper is based on data from the US stockmarket, it is an extended case study of four well known US stocks whose products almost all of us use (or have used at some point). We strongly recommend that you spend 20 minutes reading the whole paper because you will then realise why it does not make sense to worry about some of Marcellus’ holdings – like HDFC Bank, Asian Paints, Titan and Dr Lal Pathlabs – basis their recent share price performance OR because of the volatility in their returns. The paper begins by explaining why long term investing (i.e. buy a good company and sit on it for decades) is very hard to do: “Never wish to show courage, a wise man once counseled; courage can be displayed only in circumstances where one’s natural instinct is to be afraid, and fear is an unpleasant emotion. This principle, with obvious qualifications, applies to investment management. Successful portfolio management can require holding positions when one’s natural instinct is to sell.” The authors then put the reader in the position of a long term ‘buy & hold’ investor who on 31st Dec 1999 has selected four stocks – stocks A, B, C & D – basis the recommendation of her favourite Wall Street analyst. Before allocating money to these stocks, the investor opens a bottle of wine and a genie appears. The genie can see into the future and thus gives the investor a bunch of forward looking data on the risks associated with these four stocks. For example, the genie says that over the next 20 years, the number of days on which the cumulative returns from EACH position will beat the S&P500 are as follows: Stock A 79%; B 62%; C 67%; D 95%. The genie says that over the next 20 years, each stock will be more volatile than the S&P500 (using standard deviation as a measure of volatility): Stock A 40%; B 47%; C 25%; D 15%; S&P500 14.5%. “The genie next tells you about the frequency of large losses. Will any of the four stocks decline more than 10% in a single month?” Here are the % of months with greater than 10% losses: Stock A 11%; B 13%; C 5%; D 3%; S&P500 1%. “The genie reminds you that some loss periods don’t correspond neatly to a single calendar month.” Here is the data the genie presents which shows the maximum peak-to-trough loss each of the stocks will endure: Stock A -75%; B -74%; C -52%; D -26%; S&P500 -51%. Upon seeing all this data, the investor’s middle class heart starts thumping loudly and he is increasingly worried about investing Stocks A & B. Yes, A & B are outperforming the index most of the time (with A outperforming 79% of the time) but on every risk measure they look likely to give him a wild ride. The investor winces at the thought of how many Zoom calls he will have to do with clients over the next 20 years explaining that A & B are good investments and that it will all be fine in the long run. And then the genie applies the sucker punch: “Suppose your clients invest $1,000 in each stock. What’s the minimum value they’ll have in each position?” Here is the data: Stock A $275; B $78; C $549; D $842; S&P500 $575. The investor is now truly nervous about Stocks A & B: “Stocks A and B, by every measure, seem substantially more volatile than Stocks C and D. Knowing this, are you still willing to buy A and B for your clients? You know that stocks fluctuate, but you also remember that most stocks underperform the market over time.4 When the $1,000 you invested in Stock A is worth only $275, will you still have faith in the forecaster who recommended it? More importantly, will your clients still have faith in you? It would be entirely understandable if, at some point between $1,000 and $275, you decided that the forecaster was, if not wrong, at least no longer worth the trouble of defending.5 Knowing what you now know about the risk of the four recommendations, would you be willing to buy and hold all four names? If not, which ones would you eliminate?” Then, as in a 1980s Bollywood movie, 20 years pass in the blink of an eye and the investor is sitting in 31 Dec 2019. Here are the returns from the four stocks (with their real names): Stock A (Apple) 25%; B (Amazon) 17%; C (IBM) 3%; D (Exxon) 6%; S&P500 6%. Hopefully, you can now see why we love this paper – if basis the “risk” data, the investor had abandoned A & B and just loaded up on C & D, you would not rate him as a high quality fund manager: “Stock A, Apple Inc., was the best performer in the S&P 500 for the 20 years in our study, and Amazon (stock B) wasn’t far behind. Stocks C and D, better known as IBM and Exxon, both underperformed the market. On every risk dimension, the two best performers were the more volatile holdings. This is important, because volatility tests an investor’s conviction—if every stock you bought always went up, you’d never wonder whether you’d made a mistake. When you’re losing money on what you thought would be a winner, doubts inevitably creep in. What…the earlier volatility evidence suggest is that sometimes the stocks you will have most wanted to own are the hardest to hold.” The paper ends with the ‘moral of the story’: “Over long horizons, most stocks underperform the market as a whole. The challenge for an active manager is not limited to identifying the relatively small number of long-term winners. Success also depends on holding on to them when they go through painful periods of underperformance. Conviction and confidence are not enough to win the day—courage is also needed, and most needed precisely when it’s hardest to muster.”