The hardest part of investing is enduring drawdowns

Red and Green Guide:

What is truly valuable is to adopt a new information system to understand the world—to engage with the most outstanding thinkers, top scholars, and exceptional entrepreneurs.

Source: Smart Investors

James Anderson joined Baillie Gifford in 1983, became a partner in 1987, and later led the Scottish Mortgage Investment Trust, transforming it from a regional fund into one of the world’s most renowned growth investment flagships.

Over 20 years, he delivered approximately 1,500% returns for shareholders, compared to the FTSE Global Benchmark Index’s 277% over the same period.

His investment career is marked by many classic cases: he was among the earliest institutional shareholders when Tesla’s market cap was just a few billion dollars; he bought Amazon around 2004 and Tencent in 2005 (shortly after its IPO)—and held them long-term.

Anderson, driven by long-termism and imagination, bet on these super-winners, constructing a long-term compounding curve powered by the "80/20 rule."

After retiring from Baillie Gifford in 2022, Anderson didn’t step away from the investment stage but pivoted to new platforms.

He first became the non-executive chairman of Savik Capital, the holding company of Norway’s Skagen Vekst fund, and now serves as the managing partner and Chief Investment Officer of Innovation at Italy’s Lingotto Investment Company, owned by the Agnelli family.

In his new role, he continues to uphold the philosophy of "finding the few great companies."

In early 2024, James Anderson spoke at Skagen Vekst’s New Year strategy meeting under the theme "The Failure of Alpha," confronting a harsh reality: market returns almost entirely come from a tiny fraction of companies.

Since 1926, 57% of U.S. companies have underperformed Treasury bonds over their lifetimes; since 1990, a third of the U.S. stock market’s excess returns came from just 10 companies; globally, only 1% of companies have created all excess value since 1990.

The market has never been a world of averages but one driven by the power law—where a few winners dominate.

In Anderson’s view, the real challenge in investing isn’t discovering these great companies but enduring their inevitable massive drawdowns.

All 72 of America’s greatest long-term companies have, without exception, experienced declines of over 40% multiple times. Many investors couldn’t endure these periods and ultimately missed out on true compounding opportunities.

His perspective remains sharp as ever: volatility isn’t risk—it might even be the opposite of risk; short-termism is eroding the entire industry; while most fund managers chase quarterly performance, the real task is to play a different game—one others aren’t playing—by seeking companies that remain "crazy" enough to tackle fundamental problems.

In short, this speech was strikingly unique, deeply personal, and even stirred a sense of awe for the vast unknown.

Consider some of his past statements, like: "I absolutely agree that one must do something brave, radical, even something that may be overly optimistic about one’s own capabilities." This explains why he so firmly believes in Elon Musk.

But James Anderson’s mindset is remarkably open.

You can see this in the investors he admires, like Bill Miller; he also deeply respects the Santa Fe Institute—yes, the very scientific institution where Soros and Miller engaged in "thought experiments."

This is Anderson’s investment philosophy: faith in imagination, long-termism, and exponential power. He doesn’t promise next year’s returns but firmly believes that finding and holding onto the few truly great companies will ultimately far exceed market expectations.

II. Performance Is Almost Always Driven by a Handful of Stocks

Our topic today is: The Failure of Alpha. And what else we can do for our clients to help them make money in the coming years.

I’m not accustomed to discussing investment opportunities for a single year in isolation, but I’ll try to address the underlying logic.

Over the decades, one thinker I’ve most admired isn’t from finance but a cross-disciplinary practitioner—the late, great Swedish statistician Hans Rosling, renowned for his infectious data storytelling and myth-busting perspectives.

He once said something brilliant: "You should let data change your way of thinking."

I was pleased someone earlier quoted Arthur Conan Doyle, so I’ll add Sherlock Holmes’ line: "It is a capital mistake to theorize before one has data."

So, let’s look at the data itself. What investment behavior truly create Alpha (excess returns) and real value?

Many will tell you this performance can be read from a standardized bell curve. Gaussian distributions allow for mathematical derivations, like calculating so-called "risk" or even defining risk directly as "volatility."

But the question is—is this really reasonable? Can concepts like Alpha or the Sharpe ratio truly explain the investment world?

Do these theories and models even exist? The answer is likely: no.

I hope everyone maintains an open mind, as Conan Doyle advised: "The human brain is like an empty attic—you must fill it with experience."

My first unease with all this came from facing reality: performance is almost always driven by a handful of stocks.

Whether you admit it or not, or whether peers like it, the fact is: in most years, returns hinge on three to five stocks. The rest don’t matter—even losses are irrelevant. What truly determines success is the rare super-winners.

To understand this phenomenon, I sought out Henrik Bessembinder at Arizona State University.

I remember visiting him during Scotland’s coldest winter. His research traces U.S. markets back to 1926—an excellent starting point. You could also start from 1990, as global market data before then is incomplete.

What he did was simple: look back at the rawest data to see where market returns actually came from.

This approach is something Conan Doyle and Hans Rosling would appreciate.

The results were shocking, increasingly extreme, rendering any effort to understand markets through "averages" or "normal distributions" fundamentally flawed.

Here are some hard facts:

Since 1990, a third of the U.S. stock market’s excess returns (vs. Treasuries) came from just 10 companies.

From 1926 to 2016, just 90 companies accounted for half the market’s value creation; today, that number has dropped to 72.

Globally, since 1990, only 1% of companies created all excess returns.

I could go on, but the core conclusion is clear: the market is never a world of averages but one ruled by the "power law."

So, how should we interpret this?

I believe what’s more unsettling is that the entire logic behind asset pricing models (CAPM) lacks factual basis.

Since 1927, 57% of U.S. companies have underperformed Treasuries over their entire lifetimes.

In other words, holding stocks doesn’t inherently offer systematic returns.

III. The Hardest Part of Investing

Isn’t Finding Winners—It’s Surviving Their Drawdowns

If so, where does "mean reversion" even come from?

In such a world, defining a meaningful "mean" is nearly impossible due to extreme variability.

This leads to deeper questions.

First, you can only see these patterns by extending the time horizon and adopting a long-term perspective. This is also why mistakes keep recurring.

Analyzing data daily, monthly, quarterly, or even annually won’t reveal these patterns.

True wealth creation only becomes visible over decades—or across a company’s entire lifecycle.

Short-termism has infiltrated everything we discuss. That’s the core issue.

You know what? Facing this reality, I must say—though it may sound impolite to the hosts—I refuse to focus solely on this year’s investments.

So when asked: What will happen in 2024?

My answer: What we’re discussing today only manifests over long cycles.

As I’ve stressed, "volatility" isn’t a valid risk metric—in fact, it might be the opposite of risk.

Look at America’s 72 greatest companies: every single one has suffered at least one—often multiple—40%+ drawdowns.

These moments are actually opportunities the market gives you to correct the mistake of not buying them earlier.

To me, the hardest part of investing isn’t finding these companies—it’s surviving their drawdowns.

IV. Investing Means Being Different

Identifying the Common Traits of Truly Great Companies

So, the question arises: Will this pattern continue? Or will we enter an era where many stocks outperform?

I don’t think so.

Partly because IP-driven companies naturally operate in a "winner-takes-all" dynamic, making dominance easier than in other business models.

Since Microsoft’s 1986 IPO, IP-centric firms have grown increasingly vital, their dominance ever-strengthening.

But the deeper issue lies within our industry itself.

Markets are becoming less efficient, not more; short-termism is intensifying; worst of all, diversity in investment thinking is vanishing.

I respect anyone doing things differently. What I truly despise is the quarterly-earnings-chasing, 1%-ahead-of-the-market mindset—utterly meaningless.

If you’re Renaissance Technologies, pushing quant to its limits, or a deep-value investor, I admire that.

I don’t want everyone thinking like me—I want them to dare to differ.

So I’d say: We must play a different game, not the same one as everyone else.

I’m Scottish. I know our football team won’t win the World Cup. Maybe beat Norway? That’s doable.

But switch games? Darts or snooker—even if out of shape, you can still become world champion.

The key: Play a game no one else is playing.

Investing’s the same.

Our goal shouldn’t be "beating the market" or "predicting the next 12 months"—it’s identifying the shared traits of truly great companies.

If you recognize one or two at some point and hold them for a decade, it won’t matter if the rest underperform.

To me, this is "buying growth at unreasonable prices."

Everyone loves buying growth at fair prices—it feels safe, comfortable. But in markets, comfort is dangerous. Investing should leave you feeling exposed.

That’s the essence of buying growth unreasonably.

Why unreasonable? Because most companies won’t deliver the explosive returns you hope for—so in that sense, you overpaid.

But if just a few become true super-winners, their performance overwhelms everything. You’ll still reach the finish line.

My key message: Nearly all the great companies we’ve held saw profits, cash flows, revenues, and stock prices far exceed our wildest initial expectations.

This triggers complex psychological reactions in investors.

Because it upends how analysts are trained. We’re taught to be rational, value, predict—but seizing such opportunities requires imagination.

You must accept: Things likely won’t go as expected—and endure that uncertainty.

Take Tencent. Looking back at our early reports, the analysis seems myopic. We couldn’t fathom it becoming what it is today.

I could list many such examples. So you need a fundamentally different mindset—deep imagination.

But why is this getting harder?

I once joined a discussion with Bill Miller and Charlie Ellis, an early CFA thought leader who’s written extensively on market efficiency.

Ellis argues markets are harder to beat because the industry has hyper-specialized.

I partly agree. Yes, more analysts work harder and smarter today (though not smarter than Bill).

But that’s also the problem—this very professionalism exacerbates issues.

I come from a medical family. If most doctors say something’s true, it likely is. If most investors say so, wait before believing.

The "markets grow more efficient" narrative is wrong—directionally wrong.

Why? Data doesn’t lie.

Today, ~220,000 hold CFA charters. Whatever they claim, CFA curricula still center on Sharpe ratios, Markowitz, efficient markets—investment dogma.

Yet Bessembinder’s paper? Only 45,000 reads—up from years ago, but the gap remains vast.

This directly shapes most investors’ behavior—my greatest concern: it’s becoming dangerous.

I serve on university investment committees. Meetings start with: "We focus long-term; quarterly noise means nothing."

Then discussions turn as short-sighted as everyone else’s.

Frankly, I’m tired of debating "the Fed’s next move." That’s useless.

Which brings me to my final point—and thoughts on moving forward.

V. Investing Should Focus on Helping

Companies Solving Fundamental Problems

This leads to my closing emphasis: We must radically rethink fund management.

Most of us grew up with an outdated notion: stock markets, like the 1800s, allocate societal capital—building canals, railroads, driving progress.

Today, that’s not what we do.

Decades of financialization have inflated our egos.

Tom Wolfe’s The Bonfire of the Vanities depicts a failed "hero" whose wife explains his wealth: "It’s like baking a cake."

Except they weren’t baking—just passing the cake around, keeping golden crumbs each time.

A perfect metaphor.

Now, we must return to actual baking—doing something truly useful.

This doesn’t mean accepting low returns. Chasing quick profits often yields none.

Adopt "indirect thinking": How are great companies truly built?

Take our era’s most urgent theme: focus on companies tackling existential problems.

I’ve disagreed with Elon Musk—he can be abrasive. But I admire his Le Soir interview:

Asked why make EVs, he cursed (I wonder how it sounded in French), but his point was clear: "If you think I’m here for easy money, you’re a f***ing idiot!"

Auto manufacturing is brutally hard, undergoing massive tech shifts. But climate change is our era’s defining issue—and EVs are part of the solution.

Investors must ask: Can we back companies solving fundamental problems?

This requires long-termism, imagination, and understanding exponential forces.

That’s our core cognitive task.

VI. Adopt a New Information System to Understand the World

Hold Fast to Long-Termism

Earlier, Chip Miller noted semiconductors’ unique context here.

I agree. Their implications are profound.

ASML traced Moore’s Law’s origins—not just to Gordon Moore’s 1960s paper, but further back.

They believe its roots stretch to 1900. From then to now, semiconductor performance improved by?

9 × 10¹⁸ times! That number staggers.

Foresee this trajectory, and you’d struggle not to profit; stand in 1900, and you’d never imagine its impact.

That’s the cognition needed.

Where does it come from?

This may offend some, but: I haven’t discussed stocks with sell-side analysts in decades (except to arrange meetings). Their role pulls you into short-term guessing games—useless for investing.

True value lies in adopting a new information system to understand the world.

Engage with the world’s greatest thinkers, top scholars, and exceptional entrepreneurs.

Our best insights—my deepest epiphanies—came from such exchanges. From the Santa Fe Institute to individual scholars—these are the real sources.

In renewables and batteries, MIT’s Jessica Tran predicted trends 15 years ago—not flashy leaps, but trustworthy trajectories.

This is nothing like market predictions.

Let me end positively, despite the world’s absurdities and disasters, recalling Hans Rosling: "Human progress often happens quietly."

Semiconductors’ exponential change now spills into other critical fields.

We largely have the tech to combat climate change—the challenge is deployment and pricing.

More exciting: healthcare. Long Moore’s Law’s antithesis ("Rom’s Law": stagnant performance, rising costs), combining genomics, big data, and AI may rewrite biology.

A potential revolution.

Notably, many such firms aren’t today’s darlings—unlike the "Magnificent Seven."

So, my greatest wish?

I’d rather be 40 years younger than have 40 years’ experience.

Because with independent thinking, long-term vision, and these forces at your back, the opportunities are thrilling.

Will this translate to 2024 returns? I can’t promise.

Nor do I care.

Our real task: Help world-changing companies achieve greatness. Long-term, they’ll deliver returns far beyond expectations. But not annually.

Hold fast to long-termism—that’s my closing note.