If there was a way to increase your investment returns, would you try it?
If you’re reading this, I’m guessing that your answer is “yes”.
Most people think the best way to earn higher returns is to “get in early” on ideas, take on more risk, or get better information. However, I’m going to propose that you can also achieve higher returns by looking at the past–your trading in particular–to better understand how you can outperform your current investing decisions.
One way to spot areas of potential upside is to keep track of assets we sold.
Wait, why should we pay attention to assets we already got rid of?
The reason is that post-sale performance gives clues as to how you can improve your future investing decisions.
Convergent academic research from various fields, our own data, and my experience show that humans are risk averse, meaning they make financial decisions that give them the safer reward–not the most beneficial. Research shows that many people don’t participate in financial markets at all, and among those that do, they buy overly safe assets (such as bonds instead of equities), miss out on huge gains, and sell winning stocks too quickly.
Let’s focus on that last behavior: People often sell stocks that have increased in value because of risk aversion. Such behavior means they prefer to have the cash instead of risking the gains. This action would be all good and dandy if it weren’t for the fact that selling winning assets too early is a major reason most active investors–professional and self-directed investors–underperform the market.
Timing peaks is a nontrivial task that few can consistently do, but that’s not the main issue here–exiting a winning position while significant gains are still coming is the issue. If the investment thesis is intact or strengthened, macroeconomic factors provide tailwinds, and other positive considerations support a “buy” or “hold” decision, then you’d think that people would follow this logic. Yet evidence shows that people often sell for other “behavioral” reasons, such as, you guessed it, risk aversion.
The key point of the invisible portfolio is to help people ascertain their own motivations and separate “behavioral” from rational decisions to improve performance.
The stock market doesn’t care what you paid for something, only you do.
Let’s put it another way: The stock market doesn’t care what you paid for something. But you, as an investor, might be focused heavily on your own average cost basis—known as ACB. The consequence of this myopia is that investors buy and sell in relation to their ACB as their primary reference point.
You might be thinking that buying and selling decisions should be based on your own profit and loss is completely reasonable, and from a risk management perspective, this makes some sense. However, the broader view that allows for more objective decisions dictates that being highly sensitive to unrealized profit and loss, known as “PnL”, instead of considering the relevant and timely factors frees investors to earn higher returns through increasing their tolerance for gains. (I’ll discuss in another article how it also reduces losses.) Many assets that rise in value continue to do so due to momentum. Therefore, selling too early due to risk aversion often means missing out on more significant gains that would have been probabilistically predicted ex-ante for some assets.
Once we sell assets, we might lose sight of them and most likely not have precise accounting of our disposition costs. This situation is why I call the sold assets the “invisible portfolio”, so that investors can have a clear view of the performance of these unseen holdings and quantify the performance of what we could have earned had we not sold. The advantage of monitoring this is that we can see if they outperform the stocks we still own and give insight into whether we are making systematic selling mistakes.
How was the “Invisible Portfolio” invented?
In addition to considering the impacts of risk aversion from the academic literature, I had a personal experience with it that revealed my own “invisible portfolio”. I encountered this circumstance when a Dividend Re-Investment Plan (DRIP) issued shares after I sold a position after a big gain and had a few shares deposited in the account. Full disclosure: I sold without a defensible economic rationale, it was pure risk aversion, and I even knew it; more on this later.
My “ah-ha” moment came when sold shares skyrocketed.
When I saw those shares continually increase in value, eventually becoming the top-performing stocks or top-performing “Lamborghinis”, I had an “ah-ha” moment concerning my portfolio. I concluded I should keep track of how risk aversion-driven or rational selling decisions impact my portfolio! Right there and then, I devised a low-tech monitoring system by selling all but one share so I could see the “counterfactual” and keep track of my rationale for each sale. Lo and behold, I found that those single shares continued outperforming my biggest holdings, suggesting that I was selling too soon and making systematic mistakes.
In a Prof of Wall Street research meeting, I proposed that this “anomaly” be researched further and perhaps be put into production as a fintech product. Over months, the team and I developed a framework to help us study this phenomenon and build technology that can read your trade data, parse it for these specific decisions, and place them into a “sub-portfolio” for analysis.
I’m proud to say that this analytic is now available in our investor analytics reports and has helped people improve performance by seeing a new, previously unseen angle into their own investment decision-making.
How does the Invisible Investor help me be a better investor?
Seeing significant gains in stocks sold forces us to revisit the rationale used to sell the asset and consider why we missed out on profits. If the answer is that risk aversion drove us to sell gaining stocks at relatively small gains, this can be fixed as we now know that this is not a good reason to sell something. This is not to say that assets should never be sold, only that they be sold for the right reasons and at the right time.
Now that we have this quantitative tool and associated knowledge of why it’s essential, we can pause before selling assets and recognize when the motivation to sell is an irrational fear. I imagine I speak for most of us and say that I would rather have outperforming assets even if doing so makes me feel uncomfortable. Succeeding in this specific way requires understanding one’s own unique risk aversion levels and their impact on their portfolio to date. This means paying attention to the performance of assets sold and keep in mind the potential losses before allowing the irresistible tug of fear to push to sell too soon.
That said, the Invisible Portfolio performance alone is not always directly diagnostic. As is true with any statistical measure, sufficient data are needed to draw meaningful conclusions that lead to changing future decisions. The first step is to contextualize the volume of trade in the Invisible Portfolio relative to total trading.
For example, I’ve evaluated portfolios where the invisible portfolio dwarfed the actual portfolio performance. Yet, the closer analysis showed that the trade volume was low, so that I could not draw strong conclusions from it. On the other hand, some Invisible Portfolios show significant volume and dramatic performance differences that provide stronger evidence of systematic gains left “on the table”.
Knowing is half the battle, but intelligently executing a trade requires another battle, so I built an intelligent pre-trade system to help investors make fewer of these mistakes. This pre-trade process allows you to clarify and encode your motivations, beliefs, and biases in a ledger before you make a trade decision. This enriched trade history will let you see more clearly the scenarios where your decision-making led to good and bad outcomes and what underlying factors you were considering at the time. This system is the first of its kind to help you improve your performance and give you a greater sense of control over your portfolio. You can learn more about this intelligent pre-trade system on my website.
If you’ve read this far chances are that you’re interested and motivated to improve your investing performance through understanding your unique investing patterns. Most people are afraid of looking into their own performance out of fear of finding something they don’t like. But those who do share the ranks of the world’s best athletes, speakers, CEOs, and every other professional hierarchy because they are open to improvement. The best basketball player in history, Michael Jordan, once said “My best skill was that I was coachable. I was a sponge and aggressive to learn!”
The objective is to see the returns in your invisible portfolio reduce in value over time so that the assets you hold continue to rise, rise, and rise instead of being prematurely sold. This is a worthy goal and one that I hope to be able to help you achieve; reach out to discuss this and how Prof of Wall Street can help you improve your performance.
Invisible Portfolio Quiz
1. Why is it essential to track our “hidden portfolio”?
A. It gives us an accessible counterfactual of past decisions.
B. It provides an estimate of the gains that could have been realized had assets not been sold too soon.
C. It provides an indicator to use in tandem with other factors to make decisions readily.
D. All of the above are correct.
2. Suppose someone has an invisible portfolio performance of +23% since account inception, and their portfolio performance is +5%. What conclusions can we draw from this?
A. That they sell winning assets too quickly
B. They sell losing positions too slowly
C. They are good stock pickers
D. More data needed
3. For which common behavioral reason do people sell winning assets too quickly?
A. They thoroughly analyzeeach asset and are systematically incorrect about their conclusions.
B. They fear that assets that increased in value will reverse and drop in value, so it is better to sell than incur a loss.
C. They find better investment opportunities and move the capital to them instead
D. They have strict profit-taking rules and they execute decisions based on them
4. How could invisible portfolio performance be deceptive?
A. If the entire market is doing poorly
B. If the S&P is experiencing higher-than-usual volatility
C. If the total volume of sold assets is small relative to traded volume and incorrect conclusions might be drawn
D. If interest rates move down unexpectedly
Answer key: 1:d, 2:d; 3:b, 4:C