On learning the right lessons

Hello Ultimate Value readers!

I was inspired to share a few general thoughts on investing mistakes. This is my first-ever post that is not specific to a stock or company. Let me know your thoughts and comments below. Thanks for reading!

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We all make mistakes. The best investors in this game make mistakes 40% of the time. For us mere mortals, making mistakes 45% of the time is a goal we can aspire to.

But when is a mistake really a mistake?

One of the hardest things in investing is trying to figure out what the right lesson is once you’ve had an investment that did not work out. Did it not work out because your thesis was wrong? Did you get the timing wrong? Or was it simply bad luck?

While the market might have feedback for you every day in the form of price action, it never really tells you if and where you were wrong. As an investor, you are ultimately the one who has to decide whether there is a lesson to be learned.

As an example, say you have a thesis for why stock XYZ should be worth more than it currently trades for. Your thesis lays out, in a way that’s observable and quantifiable, what you expect to happen for the stock to appreciate to your price target. You invest in it, and it doesn’t pan out. But you stick to your process and cut the position when you see that your thesis is off-track. Perhaps you lose some money, or maybe you break even. Is this a mistake?

I would argue that it isn’t. You did your research; you followed your process. The results were not what you hoped for. But that isn’t a mistake.

I think a lot of investors get this wrong. They see mistakes as outcome-driven rather than process-driven. Any stock that did not work out is a mistake; consequently, there must be something worth learning from it. I think that’s inherently dangerous. Learning the wrong lesson is worse than learning no lesson at all.

Sometimes it’s even trickier than that. You get the fundamentals right and you pay a reasonable price, and a stock does nothing; or worse, it goes against you. Perhaps due to our human nature, there is a strong tendency to draw some causal link. The natural reaction is then to say, “I will avoid these stocks, they never work.”

But you have to come at this from a “first principles” line of thinking. Is there a real, fundamental reason why a stock with improving fundamentals (i.e. growing free cash flow per share) should not be worth more over time? Sometimes there is. But oftentimes, there isn’t a good reason why it shouldn’t work. Something “not working” in the past isn’t a good reason why it won’t work in the future.

As most investors know, there are long periods of time when certain styles (small-cap, etc.) or factors (value, etc.) are massively out of favor. If “value” worked all the time, everybody would be a value investor; then, as everybody became a value investor, they would bid up the prices to a level where it would stop working. As Buffett put it once, “What the wise do in the beginning, the fools do in the end.”

But you should be wary of drawing the wrong conclusions and setting arbitrary rules for yourself that might do more harm over time. There are pockets of the market that have done terribly over the last few years (small caps, emerging markets, etc). But don’t dismiss entire areas just because they haven’t worked in the past. If anything, the valuations will reflect this. At some point, the seeds will be there for the next opportunity. And if you drew the wrong lessons, you won’t be there to profit from them.

So if you make a mistake, first, don’t beat yourself up, we all make a lot of them. But if you do make a mistake, try and learn from it, but not too much.