When is Conviction actually Delusion?

For the first time in a while, I picked up a paper copy of the Financial Times this weekend. Although I’m a regular reader of the paper, I tend to consume the digital copy more than the paper version these days and it was quite a decadent treat to enjoy leafing through the original format. The weekend magazine has a fantastic article on Cathie Wood, written by Harriet Agnew. By the time this article is published, I imagine most readers will struggle to get hold of the weekend edition of the paper but I’ve included a link and highly recommend that readers visit the site and read the article. The reason I enjoyed the article so much was because of the fascinating psychological profile of a popular investor that has strong conviction.

For those that aren’t aware, Cathie Wood is the founder and Chief Investment Officer of Ark Invest; an investment platform that provides access to a range of Exchange Traded Funds (ETFs) that are actively managed by Cathie and her team. Her funds focus on what she describes as “Disruptive Innovation” and has outlined her belief that the technologies in her platforms will upend the “traditional world order”.

ARK offers a range of funds led by the flagship Ark Innovation (ARKK) which returned an astonishing 157% in 2020 due to a sudden surge of interest about the technology platforms that make up the fund such as DNA sequencing, energy storage and blockchain technologies. The stellar returns led to an enormous inflow of investors and Ark’s funds under management skyrocketed. Since then, inflation has picked up, interest rates have started to increase, and investors have abandoned Cathie as quickly as they leapt to invest with her, causing her funds under management to crater by over 50% from $60bn to less than $30bn.

In recent interviews, Cathie has doubled down on her positions – stating that she believes her team undertake some of the best research of any fund house and that anyone betting against her is really “betting against American innovation”. The word hubris springs to mind but some investors would simply call it “conviction”.

What is investing conviction?

When a portfolio manager makes an investment, they are making one of two statements. If long on a position, they believe that the company will be valued more highly by the market in the future, or if short, that it will be valued less highly. This belief is backed by their conviction, a mental state in which the portfolio manager believes that what they believe is true.

Without conviction, the portfolio manager is little more than a speculating gambler; they ‘hope’ that their investment will turn out as expected but have no strong belief that it will. As such, there is nothing wrong with having conviction when making an investment; after all, if you have done your research, you ought to have developed an informed opinion and investment thesis that will work in your favour.

Conviction can be a double-edged word, however, convincing investors to hold positions long after they should have cut loose. The strength of research and time a portfolio manager spends developing their investment thesis causes them to start suffering from confirmation bias, where they begin to dismiss evidence that they are wrong and place greater importance on evidence that their thesis is correct. As positions begin to rout, first by ten, then twenty, thirty, and fourty percent, the investor becomes ever more convinced that in time they will be proven right, often doubling down on losing investments, increasing the value of their risk capital, and ignoring stop losses, if they use them at all (disclaimer – I do not!).

Despite outstanding historic returns (over 30% per year over the last five years), some commentators are now beginning to tar Cathie Wood with this brush, stating that her conviction is actually just non-existent risk management and an active decision to ignore reality as sky-high valuations come back to normality. Just because Cathie thinks that these companies should be valued at P/Es of 50, 60 and 70 doesn’t mean that they should be and the multiple compression is clearly working against her as she watches funds under management bleed away.

In all of these examples, your conviction has simply become poor risk management and/or a choice to ignore reality. You are confusing conviction with what you want to happen. However, what you want to happen may not be what is happening. And you can watch your money bleed away before your eyes as you let your conviction overtake you.

Examples of where my own conviction has gone wrong

Rather than dragging Cathie through the mud, I wanted to demonstrate that conviction can work against any investor. At multiple times over my investing history I’ve been extremely convinced of what a great investment I’d made and watched as my position routed against me. Thankfully, I long ago managed to ditch the habit of averaging down blindly and am now much more cautious with the way I deploy capital into existing positions.

One of the biggest losses I ever suffered was on Carillion, the multi-national construction and facilities management company that went into liquidation in early 2018. The company is the only company I have held all the way to ground zero for an eye-watering 95% loss of capital (with a measly 5% being accounted for by dividends). Carillion isn’t the only company I’ve lost money on though, Xaar Group, a technology business, lost me 87% of my original investment, Saga Cruises set me back 86% and Ted Baker set me back 72%.

I’ve also held on to some companies longer than I ought to have done, watching capital gains ebb away after an opportunity to take profits. Anglo-Asian Mining was a company I bought in 2019 at £1.26, topping up several times over the years with a price target of £1.75. And what did I do when it reached my price target in January 2021? I got greedy and held my position. The shares then began a long decline, which they still appear to be in, currently sitting at £1.05. I sold the position back in December at £1.10, well below my purchase price and was still in two minds as to whether I should hold on some more. Thanks to dividends, I made a total return on the investment, but it goes to show that no matter how disciplined we think we are, we can all suffer from confirmation bias.

How to avoid the same thing happening to you

I’ve found one of the most reliable methods of combating this to be regularly reminding myself that I could be wrong with an investment. I do this in a number of ways – firstly by diversifying my portfolio, I reduce the damage that a single investment can do to my portfolio. Secondly, I maintain careful position sizing, allowing no individual position to grow to larger than 10% of my portfolio (and ensuring that these concentrated positions are only held in fairly dull investments like Warehouse REIT rather than speculative and non-profitable businesses of the variety that Cathie Wood has stocked up on).

I also, much to the consternation of several fellow investors, view every investment I review as though the worst is going to happen. Company is profitable today? Not if costs triple. Technology is loved by the market? Not if a competitor develops something better. Shares are at a 30% discount to Net Asset Value? Only if the company isn’t forced to make a 30% write-down.

In addition, I suffer much less with selling losing positions than I did when I started investing – I have a mental ‘red flag’ at around 30% when I really started to question my thesis, and if a share declines by 40% then I really start to question whether it still makes sense. This gives me sufficient leeway to avoid being a forced seller due to tight stop losses and account for market volatility but also gives me a good opportunity to avoid some of the eye-watering losses I wrote about earlier in this article. If I find myself saying ‘I hope it turns around\’, then I usually know that I’m starting to fixate on price more than the underlying company and have lost my emotional objectivity over time.

Having said this, if you believe that I only ever invest in dull, pedestrian businesses then you’d be mistaken. Part of my exposure to Cathie Wood developed an interest in more future-focused, growth-oriented businesses of the sort that historically I would have avoided. But unlike Cathie, I keep these to a very small part of my portfolio with fixed risk and am extremely careful about my entry timing – for example, buying Darktrace at £3.98 against a peak of £9.85 and S4 Capital at £5.18 against a peak of £8.70. I’m also not overly attached to either of these companies; although I like them enough to buy, they make up less than 3% of my portfolio between them and I wouldn’t be heartbroken if I decide they’re not working out over the long-term.

Ultimately, investing is about making money, not being intellectually correct. If you feel like you’re more focussed on other people agreeing with your investment thesis even when it’s losing you money, then that’s a clear sign that you’ve allowed your emotions to overrule your investment discipline. Every investment I hold is simply one line in my portfolio – I don’t place too much importance on any of them and try to make sure that over the long-run, the overall value of my portfolio is going up rather than down.

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