How Successful Equity Investors Avoid Common Pitfalls
Over the years, you may have noticed certain traits of successful equity managers, and certain other traits of managers that have disappointed. Here are some common characteristics we frequently see among equity money managers who have created strong long-term risk-adjusted track records for their clients.
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- Limiting big drawdowns. As we mentioned in a previous blog (The Arithmetic Behind Drawdowns and Recoveries) bouncing back from a big drawdown can take years, and the arithmetic is not in your favor (i.e. It takes a 25% gain to recover from a 20% loss). Buying undervalued stocks can help with this; their multiples tend to be lower which can help limit the downside.
- Avoiding biases like overconfidence. Some managers like to claim “investing is an art, not a science.” While this can be true in certain situations, and there is often no substitute for experience, quantitative tools can be extremely helpful in creating a structured, systematic investment process that should lead to consistent results. Furthermore, quant tools can help an investment team address human biases like overconfidence. For example, if an analyst spends two months building-out models and doing channel checks on a particular company, he or she will likely become biased toward that stock, whether they realize it or not. Having tools that automatically rank stocks according to the factors a team deems important can arm team members with ways to confront these biases. We have written more on this subject here -Why Equal-Weighted Positions Can Help Minimize Drawdowns.
- Don’t change what you do. A disciplined portfolio manager who buys high-quality stocks will continue buying high-quality stocks no matter how long a low-quality, risk-on rally lasts. As tempting as it can be to change your strategy and chase stocks or factors that have been in favor, a disciplined manager will be rewarded when the market inevitably reverts in his or her favor. One of the worst things a portfolio manager can do is abandon the principles they built a business on, chase performance, and then get “whipsawed” when the market swings back in the direction he or she just gave up on.
Other non-investment-related elements that can still affect performance:
- Fostering a strong company culture. Boutique managers often benefit from their smaller size, since management can have more control over the day-to-day happenings of the business. These smaller firms are usually independent and owner-operated too, and the employees often own equity in the company. This often results in very strong incentives since key team members “have skin in the game.” It can also result in low turnover amongst team members.
- Having personal capital invested alongside shareholders. This results in extremely strong incentives for the portfolio management team, which will usually pay special attention to limiting downside risk since their personal capital is at stake.
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The universe of acceptable investments for ESG and SRI funds may be limited as compared to other funds. Because these funds do not invest in companies that do not meet their ESG or SRI criteria, and may sell portfolio companies that subsequently violate their screens, they may be riskier than other funds that invest in a broader array of securities.