Every investor in shares has bad experiences from time to time. The stock that bombed out of the blue, the growth story that went wrong or the enticing valuation that was too good to be true. The pros have these experiences too – they just don’t tend to advertise the fact. It is accepted in fund management that getting 6 out of 10 market-beating ‘winners’ is a decent result, and with the right controls around risk and position sizing that sort of ‘hit rate’ should result in an enviable record.
Picking winning stocks is very difficult because, at the risk of stating the obvious, the future is uncertain. Uncertainty about how companies might compete, expand and adapt; industry changes, the effect of regulations; demographic trends; economic challenges – the list is endless. What you see each day with share prices bobbing up and down is investors trying to grapple with these uncertainties and ‘price’ them in. The world is, and always will be, challenging for companies to navigate. It is no surprise then that lots do fail, or else don’t add any value over and above general economic expansion.
Research from academic Hendrik Bessembinder found that the entire wealth creation of the US stock market since 1926 has been concentrated in as few as 4% of companies. This may be skewed by the recent surges in big technology companies relative to almost everything else, but it is still staggering. It reveals just how few companies end up really succeeding. The good news is that having enough of the small number of winners tends to easily eclipse the effect of the many losers.
In this context, you really don’t need to beat yourself up about your own stock-picking mistakes. They are part and parcel of the investing experience. All you can do is try and tilt the odds in your favour as much as possible and protect yourself by having a sufficiently diverse portfolio, so you are not reliant on too few companies delivering.
With this in mind, how do you improve on your stock picking by learning from your inevitable mistakes?
Mistake or misfortune?
The first thing is to distinguish between a mistake and genuine misfortune. Natural disasters and acts of God do happen from time to time and should be separated from risks that are, or should be, priced in by the investor. A company may operate in a sector or jurisdiction where the risks of doing business are simply higher. Extracting natural resources in a politically unstable country is one example where investors knowingly take on higher risks. A company must always maintain its license to operate, and if this is curtailed it shouldn’t come as a surprise to the well-informed investor that has taken account of the risks. If things go wrong in these instances you can’t simply blame the random factor of bad luck. But in other cases, you can – don’t be downbeat about these purely random events, it wasn’t your fault!
What did you miss?
The biggest piece of advice I can offer in terms of learning from genuine mistakes is to make sure you know what you own and why you own it in the first place. This wisdom is borrowed from the great Peter Lynch, acknowledged to be one of the finest fund managers of all time and author of the timeless classic ‘One Up on Wall Street’. Lynch’s mantra is that average investors can, with the right approach and research, pick stocks as effectively as the pros. Fully understanding the risks and opportunities of a business, as well as its true financial health, not only helps you pick stocks in the first place but will assist you in analysing what went wrong. Was the company too indebted? Were growth prospects too optimistic? Was it unable to execute its business plan effectively? Did it become outmuscled by more competitive rivals? Having a clear idea of why you bought a share will greatly assist in any post-mortem.
It might seem an unnecessary pain, but when you decide to buy a share write down your reasons as fully as you can. Note your concerns about any risks too. Referring back to this will be instructive as you may well forget the full rationale – memory tends to be selective. Once you have these records jotted down it will make your future analysis of what went right or wrong so much easier and help you learn from mistakes whether they are details missed, failed assumptions or forecasts that turned out to be wrong. Maybe it was just a case of buying at an unsustainable price at 'peak popularity'. The writing down process should also instil the healthy habit of always asking what might go wrong for the company before you invest. It is all too easy to focus on potential and ignore the risks. All companies face challenges and focusing on these helps avoid getting carried away with an exciting story.
Was your approach wrong?
Football managers frequently say they learn more about their team from defeats than from victories. It’s a similar story for investing Mistakes can be helpful as they can reveal flaws in your approach, so embrace them rather than bury your head in the sand. Never forget that a result by itself tells you nothing about how it was achieved. A gain might have been achieved through careful, well-informed investment or it could have been a wild gamble. To expand the football analogy, you might be fortunate enough to win the match with a speculative shot from the halfway line, but that’s not going to help with your tactics against your next opponent.
Losses from your errors can also reveal your tolerance to risk. Psychologically, losses are more painful than gains are satisfying. Logically, it shouldn’t be that way, but it’s just how the human brain is wired. Mistakes help you strike the right balance between risk and reward going forward. Resetting expectations may alter your strategy such as aspiring to adequate but consistent returns rather than an explosive performance from most of the components of your portfolio.
Sticking to what you know
Finally, mistakes may also inform your ‘circle of competence’, the areas in which, you, as an investor, has a genuine skill or edge. That might be specific industry insight or enthusiasm for a certain type of business. According to legendary investor Warren Buffett, “The size of that circle is not very important; knowing its boundaries, however, is vital.” In other words, you can’t be an expert in everything, so stick to what you know best. Mistakes can help you define what you are not so good at – and there are plenty of alternatives for covering areas you aren’t proficient in if you wish to diversify. As Tom Watson Sr., Founder of IBM, put it, “I’m no genius. I’m smart in spots—but I stay around those spots.”
It’s not just about being smart though. Sometimes a high IQ can actually be a hindrance if brings overconfidence. Thinking you know everything can be as dangerous as knowing nothing at all – and we can look to the many financial failures over the years as examples of hubris in almost every instance. Learning from mistakes and having humility tends to stand you in good stead as an investor.
A version of this article appeared on This is Money.
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