What I Learnt about Value Investing from Paul Tudor Jones
In markets as in life, we will go to great lengths to avoid pain.
We are inclined when facing a (financial) loss to convince ourselves that the asset is going to bounce back and we will break even. “It’s only a paper loss,” people will tell themselves. “It’s not a real loss until I sell.”
Or in relationships and our jobs we might often say: “I’ve already invested five years of my life into this, I can’t quit now, I have to stay with this.”
This is called Loss Aversion or Sunk Cost Fallacy, and I believe that value investors are more likely than others to suffer from it.
A few years ago I started thinking more about this problem, and realized that I could learn a lot from someone like Paul Tudor Jones, the legendary macro trader. His track record reminds me of what Warren Buffet said:
Rule No.1 is never lose money. Rule No.2 is never forget rule number one.
In investing it’s easy to overlook this. We do weeks, sometimes months of investment analysis before we make our investment decisions.
This leads to ‘high conviction’ or an inability to believe we may be wrong. When our stocks fall, we think the market is mistaken, and we should add to our position.
It becomes a question of being right, our weeks of work can’t possibly be wrong. The market is surely mistaken and we just need to give it time. We may even, like Bill Ackman – find ourselves adding to our losing position. As an aside I highly recommend you read Safal Niveshak’s post on lessons from Valeant.
Recognizing your losers is hard because it’s an acknowledgment of your mistakes – we are focused on the sunk cost of the investment. The money we have lost, rather than focusing on what more we could lose, and the opportunity cost of continuing this investment – including time & mental energy.
The fact that the stock is now cheaper, makes us even more likely to buy more, to make it a bigger bet, so we find ourselves adding to our losers. Before you know it, the portfolio is full of losers.
Many years ago Paul Tudor Jones was photographed in front of a photo that read “Losers Average Losers”. Repeat that to yourself. Losers average losers!
I have seen many investors act like losers, and I have done this myself. Averaging in is the opposite of taking a loss, it just allows the market to hurt you more, and after adding more size every move against you is more painful.
This is intellectually what value investors are drawn to – we get to pretend the stock is even cheaper now. Rather than going back to the drawing board and understanding where we went wrong – what may have happened to intrinsic value, how our thesis could be wrong – we simply add to the position.
Intellectually this is the easier thing to do.
We instantly feel like hero, like we are getting a great deal in the market.
This creates a situation where we are potentially adding to a business / stock that is deteriorating. Rather than understanding why the market may be re-pricing this stock, and why the business might be deteriorating, we simply add to the ‘cheaper’ stock. Once in a while, this works out, more often the deteriorating business /stock deteriorates further. Before you know it, the 5% position down 20% is now a 10% position down 40%. Rather than losing 1% of the portfolio, you have now lost 4% – and that’s if the stock stops there.
How do we get better:
As value investors, its important to step back, admit our mistakes. Rather than saying the market is wrong, we need to do a post-mortem.
What does the market see, that we don’t? What’s the bear thesis on this stock? What did we miss initially? It’s critical to try to understand what we may have missed initially and where we could continue to be wrong.
You have to give yourself permission to be wrong. I think Warren Buffett said it well:
You’re going to make mistakes. You can’t play in the game without making any mistakes. I don’t think about it, I just move on. Most business mistakes are irreversible setbacks, but you get another chance. There are two things in life that you don’t get another chance at – marrying the wrong person and what you do with your children. Business, you just go on. It’s a mistake to dwell on mistakes, it’s unproductive.
Paul Tudor Jones:
Here are quotes from Tudor Jones that I hold in my head and go back to on the subject of cutting losses:
If you have a losing position that is making you uncomfortable, the solution is very simple: Get out, because you can always get back in. There is nothing better than a fresh start.
One principle for sure would be: get out of anything that falls below the 200-day moving average.
5:1 (risk /reward). Five to one means I’m risking one dollar to make five. What five to one does is allow you to have a hit ratio of 20%. I can actually be a complete imbecile. I can be wrong 80% of the time, and I’m still not going to lose.
The single most important things that you can do is diversify your portfolio. Diversification is key, playing defense is key, and, again, just staying in the game for as long as you can.
I think, what he is saying is that if you don’t play defense and you lose, you are out of the game.
One of the key ideas in investing is that to be there for the good times, you have to actually be there. You can’t win unless you remain in the game during the bad times.
Playing defense and cutting your losses rather than adding to them allows you to limit drawdowns, maintain your mental strength and to be there for when the market or stock turns higher.
Diversification allows one to “practice patience.”
So any single position doing badly can’t hurt because a) it’s never large enough to blow up the portfolio and b) you never let a position doing badly inflict a loss so large that it could hurt you.
Many of us read books like the Warren Buffet Way and the Warren Buffet Portfolio, and start thinking we have to invest like Warren Buffet. That we too, should run high conviction, concentrated portfolios.
I started out like that too, but over time have realized that I am not Warren Buffet, I am not that smart, and diversification is key to protect myself for my own mistakes.
Lessons from Paul Tudor Jones:
- I approach every stock with the understanding that my knowledge is imperfect, that I could be wrong and I give myself permission to make mistakes.
- If something falls more than 10% versus the market, I force myself to re-evaluate my thesis and think about how I could be wrong – what is the price action trying to tell me.
- I ask myself if I didn’t own the stock here, would I buy it today. If the answer is no, I sell immediately.
- If something falls below its 200-day moving average I sell 50% of the position right away, and again re-evaluate my thesis.
- If a position is causing me a lot of stress or is consuming an undue amount of time on a weekly basis, I cut 50% – the position is obviously too big.
- If I wake up worried about a position repeatedly, I cut it 50% immediately.
I am sure value investors will disagree with my approach – I am wiling to consider that I am wrong and would love to hear your views on how you limit losses.
Also check out:
Books I have found helpful around trading and mental biases.
- The art of thinking clearly by Rolf Dobelli
- Market Wizards (part 1) by Jack Schwager
- Market Wizards (part 2) by Jack Schwager
- Market Wizards (part 3) by Jack Schwager
- Fooled by Randomness by Nassim Taleb
- Reminiscences of a Stock Operator by Edwin Lefevere
- What I Learnt Losing a Million Dollars by Jim Paul and Brendan Moynihan
- The Education of a Value Investor by Guy Spier
Articles with important points on when to sell:
Go ahead, see what you’ve been missing.
Join the free What I Learnt on Wall Street newsletter by signing up below
100% privacy. No games, no B.S., no spam.