Investing Mistakes Part 1: Lacking Conviction

Why conviction is an ingredient of investment success

What is conviction?

Investors use the word “conviction” a lot. We can think of conviction as the level of confidence we have in something happening. More specifically for investors, conviction refers to how much confidence we can get around how a business will perform in the future. Conviction is needed in a goldilocks dose: too little will sap your staying power in an investment when markets get choppy, and too much will cause you to dig in your heels and fail to change your mind when warranted.

How much conviction we can get on a stock is a function of how well we are able to answer questions that arise as the business is analyzed. As a rule of thumb, the greater the number of unanswered, or even unanswerable questions, the lower your level of conviction is likely to be.

A lack of conviction can stem from a variety of sources: 1) by failing to analyze the business, or when the analysis performed is of a perfunctory nature; 2) the business is of a complexity or opacity that makes it harder to derive confidence from the analysis; and/or 3) when an investor has a proclivity to be influenced by external factors, causing them to capriciously abandon their own fundamental opinions.

For any given stock we can plot our conviction level along a spectrum:

Source: Bristlemoon Capital

It is notable that hard work and astute analysis does not perfectly map to higher levels of conviction. For certain businesses, such as those that are particularly complex or opaque, the growth in the amount of conviction we hold might asymptote at a low level. Basically, no matter how much work we do, we would still be unable to get confidence in the distribution of future value outcomes for that highly complex and opaque business.

An example of this might be an early stage biotech company developing an experimental cancer drug. The company has no revenue, and the development of the drug is still in the idea phase. There is a long and uncertain road ahead for that business to develop a working drug, go through clinical trials, and receive regulatory approval. There is no amount of work we could do to get conviction around what the future holds for that company. That stock would be an easy “no” for us.

Conversely, there are high-quality businesses with simple-to-understand business models, with clear reporting of their financials, and a long operating history of strong financial performance. These are the sorts of businesses that are easier to build conviction around.

Why is a lack of conviction dangerous?

Investing without conviction is like running while blindfolded. The lack of vision will pose no issues in the absence of obstacles. But sooner or later, something will impede the runner’s path. Much like one’s vision, the absence of conviction is noticed most acutely when it is needed most. So, while everything may seem fine while stocks are rallying, a lack of conviction can impair an investor’s staying power during inevitable periods of volatility.

Why is this? Because without conviction, you will have insufficient confidence in the reasons for why you own that stock, potentially causing you to jettison the investment at an inopportune time.

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Let’s look at two contrasting examples. One is of a seasoned investor who has followed a company for 20 years and has an extensive understanding of the business and key stock debates. That investor is unlikely to be perturbed by volatility in the stock because they know the reasons for why they own that stock, and short-term movements in the stock price will fail to affect those reasons.

A speculator, on the other hand, who’s done no analysis on the company and bought the stock on a whim, will have no real conviction. So, if the stock price were to become volatile, there’s a greater chance that that individual will allow the vicissitudes of the stock market to sway their opinion. For the speculator, the price of the stock inadvertently becomes an input into their investment opinion.

This is problematic when stock prices are falling and the investor takes this as a signal that they were wrong, potentially causing them to sell the stock in a decision that’s divorced from any fundamental rationale. To quote a well-used adage, you want the market to inform you, not instruct you.

We can’t have real conviction without doing real work on a stock. Doing analysis is what provides the basis for forming a view on the value of that asset. And it is far easier to rationalize holding an investment when you understand the intrinsic value of what you own, especially when the stock price is demonstrably below your estimate of the stock’s true value. No one likes selling a dollar for 70 cents!  

Another problem arising from investing without adequate conviction is that it can lead to errors of omission by prematurely exiting investments or failing to properly size winners. For example, in situations where an investor doesn’t have a strong belief in the upside scenario (possibly because they’ve only done cursory analysis on the stock), and that stock has rallied, there’s likely a temptation to take profits or exit the position.

Taking profits might not sound like a bad outcome, but it can mean selling a stock because it’s up 50% and then the stock price rallies 5x. Building stronger conviction in that investment might have helped the investor better appreciate or believe in that upside scenario, and allowed them to extract more profit from that stock idea.

This highlights the importance of centering our decision-making around a view of the intrinsic value of a business based on fundamental analysis. The greater our confidence in that upside value, the greater the likelihood that we will remain invested despite any material advances in the stock price.

Conviction isn’t just a vibe or feeling that can be manifested. It is easy to think that you possess conviction; it is much harder to actually build genuine conviction. Genuine conviction – which is when your views are based on insights generated from cogent analysis – is what matters. Anything that falls short of this is faux conviction: an erroneous sense of confidence that is based on flimsy or no analysis. It is where self-confidence and ignorance replace an assessment based on facts and data. It is clearly preferrable to know that you don’t have any confidence in a stock call than to strongly believe in a specious and insubstantial conclusion.

Conviction and position sizing

If you have genuine conviction in a stock’s upside, based on high quality analysis that you think gives you an edge, you should seek to exploit that edge rather than neuter it. More conviction should see one’s portfolio tend toward more concentration in an effort to maximize the returns from these precious stock insights. Conversely, lower conviction should naturally result in smaller position sizes.

However, while a smaller position size can attenuate the problem of lower conviction, it is an imperfect antidote. The danger is that a smaller position size becomes the default whenever a stock has downside that is difficult to assess, creating the risk that an inordinate amount of the portfolio is allocated to situations that have highly uncertain downside. A long tail of meekly-sized ideas also risks becoming a distraction to one’s finite mental bandwidth when managing a portfolio of stocks.

In the context of a managed fund, there is the added difficulty of a portfolio manager needing to calibrate the conviction levels of the various analysts when making position sizing choices. Some analysts will skew bearish, others bullish. These calibrations can be made by understanding the various personality types, and this assessment can be supplemented with quantitative insights. For example, giving analysts shadow books and looking at how aggressively they size things can help shape the lens through which the portfolio manager can interpret their analysts’ conviction levels when recommending stocks.

There is a fine line between a lack of conviction and too much conviction. The risk of too little conviction is you leave gains on the table and may fail to outperform the market; the risk of too much conviction is you blow up and are out of the game. This balance must be delicately managed in a world of imperfect information, and where the future is uncertain. No one has a crystal ball, which means there is no such thing as complete conviction. Our convictions must always be held loosely and carefully balanced with the acknowledgement that we could be wrong.

We will explore a variety of other investing mistakes in future articles. Feel free to subscribe to receive these updates. If you enjoyed this article, please leave a comment or share the article!

Disclaimer / Disclosures

The information contained in this article is not investment advice and is intended only for wholesale investors. All posts by Bristlemoon Capital are for informational purposes only. This article has been prepared without taking into account your particular circumstances, nor your investment objectives and needs. This article does not constitute personal investment advice and you should not rely on it as such. This document does not contain all of the information that may be required to evaluate an investment in any of the securities featured in the document. We recommend that you obtain independent financial advice before you make investment decisions.

Forward-looking statements are based on current information available to the author, expectations, estimates, projections and assumptions as to future matters. Forward-looking statements are subject to risks, uncertainties and other known and unknown factors and variables, which may affect the accuracy of any forward-looking statement. No guarantee is made in relation to future performance, results or other events.

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Bristlemoon Capital Pty Ltd (ABN: 22 668 652 926) is an Australian Financial Services Licensee (AFSL Number: 552045). 

George Hadjia is associated with Bristlemoon Capital Pty Ltd. Bristlemoon Capital may invest in securities featured in this newsletter from time to time.