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Editor's note: Below is an excerpt from Hedgeye CEO Keith McCullough's new eBook, Master the Market: A Hedge Fund Manager's Guide to Process and Profit. Click here to download the book for free. |
First and foremost, we help preserve and protect your portfolio.
The opportunities that come from preserving and protecting your wealth are underestimated by most investors. Investors going through large drawdowns of their capital can’t redeploy it when compelling opportunities appear. These investors are too busy cleaning up yesterday’s mess to proactively identify the next big market move.
All of this boils down to the idea that you’ve worked too damn hard to lose -20%, -30% or -50% of your hard-earned capital.
Q: Do you know what your portfolio has to be up to recover from a -20% drawdown?
A: 25%
Let’s take a more extreme example of this drawdown math. Someone who invested in Bitcoin at the 2021 peak lost -78% by the time Bitcoin bottomed. That requires a +354% return just to get back to breakeven. If you bought the 2021 peak, it took almost 3 years for Bitcoin to get back to breakeven. Surely, there was something better to do with your money over that painful period where cryptocurrencies were finding a bottom!
Making poorly-timed investing decisions can have a profound impact on your wealth. It can also affect the well-being of your family. At the end of the day, investing is about compounding. A catastrophic error like buying the peak in Bitcoin takes you out of the game.
One of the biggest problems for anyone actively managing their own money is the inability to distinguish between skill and luck. Unchecked, our monkey brains have evolved to attribute every successful outcome to skill.
Meanwhile, bad results are attributed to factors outside our control. This line of thinking—judging your decision based on the results—doesn’t evaluate your actual decision-making process. You can make a bad (lucky) decision that generates a successful outcome and make a good (skill-based) decision that’s a loser.
World Series of Poker winner and former professional poker player Annie Duke explains this concept in her book, "Thinking in Bets: Making Smarter Decisions When You Don't Have All the Facts." Duke calls this phenomenon “resulting. "Resulting," Duke explains, refers to the cognitive bias where people judge a decision based on its outcome, rather than on the quality of the decision at the time it was made.
“Resulting” leads people to create overly simplistic narratives about why success or failure happened. If the outcome is good, the decision was good; if the outcome is bad, the decision was bad. This can distort learning and growth, as it prevents a clear understanding of how decisions impacted outcomes independently of luck or external variables.
The top performers in The Game accept that the world is filled with uncertainty, but place high-probability bets when the odds are in their favor. It’s important to note that the world’s best investors expect their edge relative to the broader market to be a success rate of between 55% and 65%.
Another way of saying that is these investors expect to be wrong 45% to 35% of the time. And that’s for pros playing at the highest level! This is a far cry from the certainty you hear on mainstream finance TV, where the line of questioning is always, “are you all-in?” on a particular trade.
What the pros know (and what I intend to convince you of in this book), is that the compounding effect of high-probability decision making is how the best investors preserve, protect and grow their wealth.
In other words, the best way to combat “resulting” is to have a repeatable decision-making process for investing. Your decisions need to be surgical. You need a decision-making process for when to get into an asset class and when you’ll get out.
This latter point is very important: A lot of people are very effective in convincing you to get into an asset, but who gets you out?
Wall Street convinces most investors to buy and hold something by pitching the comfort of long-term averages. That’s just Wall Street collecting fees and taking your money. Sure, over the long-term, the S&P 500 goes up 6-7% annually on average after adjusting for inflation. But while the long-term average could be a useful starting point, it doesn’t provide the whole picture. Just because something happens 80% of the time under a particular set of historical conditions doesn’t mean that pattern will repeat in the future. “What matters is the particular, not the average,” is a fantastic quote by the father of fractal math Benoit Mandelbrot in his seminal book The Misbehavior of Markets.
There’s a very real cost to owning something for the long-term and weathering those painful periods where that asset class goes down -10%, -20%, -30% or more in your face.
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