Every investor will have a tale of an investment that went wrong. If they don’t, they’re either lying or have not been in the game long enough.
It would be great if we lived in a world where every investment decision turned out to be a profitable one. But that is just not the case. There will be bad deals.
Companies fail for a multitude of reasons, and investors can’t screen for all of them. Even if we could, there’s no telling when the next disaster will arrive.
Even Warren Buffett, who is considered to be the world’s best investor, got caught out by the coronavirus pandemic this year.
After avoiding airline stocks for decades, Buffett had put billions to work in airline stocks over the past few years. He believed the sector’s economics had changed, and all figures pointed to that conclusion. Then the pandemic arrived.
In my experience, all investors suffer losses and make mistakes. However, what separates the average investor from the great investor is the ability to realise when one is wrong.
Losers Average Losers
Many years ago billionaire hedge fund manager Paul Tudor Jones was photographed in front of a photo that read “Losers Average Losers.” This simple statement defined his trading strategy.
With short term trading strategies, averaging down on a losing position can result in a terminal outcome. As Jones himself once said, “Don’t ever average losers. Decrease your trading volume when you are trading poorly; increase your trading volume when you are trading well.”
Short term trading strategies and long term investment plans don’t have many things in common, but I would argue that the requirement to realise when one is wrong is vital for success in both disciplines.
Short term traders focus on price. Long term investors focus on fundamentals.
For short term traders, when the price is going in the wrong direction, it may be time to sell. When the fundamentals move in the wrong direction for long term investors, it may be time to re-visit the investment case.
Many investors struggle to change course when the fundamentals change.
The cognitive bias of loss aversion is to blame. This bias describes why, for individuals, the pain of losing is psychologically twice as powerful as the pleasure of gaining. Therefore, individuals tend to prefer avoiding losses to acquiring equivalent gains.
Overcoming this bias isn’t easy, but I’ve found that a good trick to use is to view the asset sale or loss as an opportunity, rather than a failure. Rather than dwelling on the flop, I look forward to what I could do with the funds released; doubling down on a winning position or buying into a fast-growing small-cap with bright prospects.
The great thing about investing is there’s never any obligation to own an asset. The stock or bond does not know you own it. None of the company’s other investors knows you own it. You won’t get any awards or praise for holding on the longest. More importantly, one does not have to use the same investment to make money back one has lost.
Warren Buffett’s right-hand man, Charlie Munger, once noted that trying to do this was one of the most common errors unsuccessful investors make.
“That’s the reason so many people are ruined by gambling,” he said. “They get behind, and then they feel they have to get it back the way they lost it,” Munger continued.
Instead of following this destructive path, investors should “lick” their wounds and move on, he summarised.
In my view, this is one of the most valuable lessons for investors. Yes, one will have losses at some point, but that does not make one a bad investor. Bad investors double down on losing positions and make irrational decisions driven by emotions.
Great investors realise they made a mistake, learn from the mistake and move on to the next idea.