The 20% performance fee for portfolio managers is justified because their primary challenge is managing money within a strict stop-loss framework. The discipline to cut a losing position, which runs counter to the natural human instinct to buy more on a dip, is a difficult skill that commands high compensation.
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Unlike surgery or engineering, success in finance depends more on behavior than intelligence. A disciplined amateur who controls greed and fear can outperform a PhD from MIT who makes poor behavioral decisions. This highlights that temperament is the most critical variable for long-term financial success.
Top investors experience an "asymmetry of emotion." The pleasure of significant gains is muted—a feeling of satisfaction rather than euphoria. However, the pain of losing capital, particularly during irrational market events, is disproportionately intense, driven by the responsibility of managing other people's money.
During due diligence, it's crucial to look beyond returns. Top allocators analyze a manager's decision-making process, not just the outcome. They penalize managers who were “right for the wrong reasons” (luck) and give credit to those who were “wrong for the right reasons” (good process, bad luck).
Effective decision-making is not about being right all the time; it's about speed and discipline. Top traders are correct only about 55% of the time. Their real skill lies in quickly recognizing the 45% of wrong decisions and cutting their losses without ego. This principle applies to all leadership.
Challenging the Efficient Market Hypothesis, the hosts speculate that finance professionals add value beyond security selection. Their worth may come from managing client anxiety, providing risk counseling, and other intangible services that are hard to articulate but valuable to customers.
Private equity managers often get psychologically anchored to their purchase price. Instead of cutting losses on a poorly performing asset to redeploy time and capital, they hold on in the vain hope of getting their money back, turning a bad deal into a time-consuming, mediocre one.
Gurevich opposes the mechanical application of stop-losses to every position. Risk management should be at the portfolio level. Some positions become more valuable as they move against you and should be held longer. A trader must preserve the freedom to exit a trade based on a changed thesis, not an arbitrary price level.
A study in the book "Art of Execution" found the world's best investors have a win rate equivalent to a coin flip on their top 10 ideas. This proves superior returns come from how positions are managed after the initial buy decision, not from superior stock picking alone.
A core discipline from risk arbitrage is to precisely understand and quantify the potential downside before investing. By knowing exactly 'why we're going to lose money' and what that loss looks like, investors can better set probabilities and make more disciplined, unemotional decisions.
To enforce its long-term philosophy, the largest component of a portfolio manager's bonus at Capital Group is their 8-year performance record, while one-year results are the smallest factor. This structure insulates managers from short-term market pressures and gives them the necessary "time to be right" on their convictions.
