Saturday, September 05, 2009

Can we afford to make mistakes in investing?

Mistakes in life are one aspect of life which no one likes to talk about, and perhaps the one thing you don’t know well about your friends (and even your loved one) as most people are embarrassed to admit their faults. But it’s a fact of life that as human beings, we are fallible and less than perfect. We frequently make mistakes and it is a natural process of evolution that mankind learns from mistakes and avoid repeating them, or else repeats them to his own detriment. There is of course a saying that “History always repeats itself”, but in the world of investing, if history repeats itself too often with respect to mistakes, then one will end up a lot poorer.

The big question I have posed is: can we afford to make mistakes and yet come out better from the experience? How many mistakes are investors “allowed” to make before one is made significantly poorer, or significantly wiser? I think the answer to this depends on the nature and severity of the mistake made, and how much of one’s capital was staked on that particular investment in question. Giving a recent example of mine: my investment in Swiber turned out to be a mistake due to the way the Company was managing its cash flows and also to the fact that its debt levels were too high – but fortunately due to sufficient margin of safety I avoided losses and even managed to book a small gain when I divested my shares. So the idea here is to keep your losses small and manageable by adopting proper techniques to determine margin of safety, and never over-paying for any investment.

Making mistakes in investing is unavoidable, but it is the lessons we learn which are the most valuable. I personally feel that making a small number of minor mistakes is actually good for an investor as it tempers his ego, allows him to learn more about investing (as well as himself) and makes one more determined not to repeat the mistake. Of course, this is based on the assumption that one can be totally honest with oneself and admit that “it was my fault”, and not blame it on everything else like your broker, your friend who gave you the tip, the weather, Ben Bernanke and a host of other unrelated events. It is pretty easy to shift blame but ultimately one has to answer for one’s own actions as it is your money and no one else’s at stake here.

Another seldom mentioned aspect of making mistakes is the length of time required to recognize a mistake. For my Swiber investment, it took 2.5 years for me to fully appreciate the gravity of the situation and make a swift exit, but there is an opportunity cost attached to the time involved and one can argue that the money could have been deployed elsewhere to generate higher returns (on hindsight, of course). The fact that growth companies like Swiber do not give out dividends further compounds the problem of opportunity cost as there is nil return at all during the period of being a shareholder. Even if an investment were to pay say 3% dividend yield but turn out to be a mistake, one can argue that one can easily achieve a 5% or more yield investing in a variety of blue chips which offer more safety and stability. But all this is paper talk until executed; so as an investor we must learn to balance such viewpoints against the practicality of getting such returns over an extended period of time, which brings me to my next point.

An investor cannot afford to make too many mistakes of a much longer duration, as arguably there are not many chances for him to be vested for 10-15 years and observe many business cycles before realizing he has made a mistake. One’s life span is finite and full business cycles can last for 10-20 years; so one should avoid mistakes which only crystallize after a long period of time, during which the hapless investor either earns a paltry return or a very sub-par one (as compared to returns generated from an index fund, for example). So, in such cases, I would advise that investors avoid making such mistakes but instead read more books and learn from Other People’s Mistakes instead ! By distilling their experience and knowledge, one can learn from them without committing the same cardinals sins and at the same time, saving oneself 10-15 years of anguish and mental stress due to an under-performing investment.

So the answer to the topic will be: yes we can afford to make small mistakes, which is good for our ego and temperament as it keeps us grounded and rooted in reality instead of getting carried away by exuberance; but when it comes to major mistakes or those which take a long time to manifest, it is much better to learn from others’ instead of committing them yourself.


ininvestor said...

Great post, as you rightly highlighted that we all make mistakes and it's all down to us to learn from them and when the next opportunity comes around we have experience to deal with it.

Musicwhiz said...

Hi ininvestor,

Thank you for visiting. I certainly hope I know how to grab any opportunities that may come my way - paralysis can be the bane of many investors as well.


Lemizeraq said...

Hi Musicwhiz,

Think that you are being too hard on yourself. If one goes in and out of investment without some time frame in mind, even if they ultimately turn bad, one be trading not investing.

So you are doing the right thing to give the company some time to see if they can turn it around.

Great post!


PanzerGrenadier said...

Learning from books is a good starting point. But no amount of reading can bring home the lessons that the market teaches us about ourselves.

Perhaps it is this introspection and inner reflection on what went wrong/right in our investment decisions that pays greatest diviends in our lives.

Mistakes are part of the human experience. We need to guard against catastrophic mistakes that wipe us out but small mistakes are the price of being human.

Be well and prosper!

Musicwhiz said...

Hi Lemizeraq,

Haha, thanks. Perhaps I was being too hard on myself - but then how else can I improve and be a better investor if I were not? :P I think I have to constantly challenge myself to learn new things, and from mistakes, in order to improve my performance. Such is the process of polishing and refining one's techniques.

Good luck !


Musicwhiz said...

Hi Panzer,

Yep I totally agree on the books part. No use reading a lot but in the end we have no practical experience and we dare not dip our toes in to make actual mistakes. The important thing is to keep the mistakes small.

To err is human. Only through this process can we progress as a species and evolve to be better people.


CK said...

Good day.
Very interesting topic you got here. I'll just add this quote:
"Every adversity, every failure, every heartache carries with it the seed on an equal or greater benefit. - Napoleon Hill"

Musicwhiz said...

Hi CK,

Hey thanks for visiting and also thanks for the quote!