Finding and fixing mistakes is very important…

Most equity professionals will tell you that it’s at least as important to identify and fix mistakes as it is to find and hold stocks that will outperform.  Yes it’s a cliché, but that’s another way of saying it’s really and obviously true.

…but it’s harder than it seems

It’s less likely that a professional will tell you how hard this is to do.  It may be they’re unaware themselves.

I picture the situation as being like a professional baseball hitter coming up to bat.  On the one hand, he is absolutely convinced that he is going to hit the ball safely and get on base.  On the other hand, if you ask him what his chances are of hitting .400 for the year (that is, hitting safely in 40% of his at bats), he would probably laugh and say that no one in the major leagues has done that in over fifty years.

Similarly, every time an investment professional, or any of us, for that matter, makes a trade, we all think–whether we are conscious of this or not–that we know better than the guy on the other side.  If we’re buying a stock we think the seller is foolish to part with it; if we’re selling, we think the buyer is overpaying.  At the same time we know, at least intellectually, that two-thirds of the professional active managers in the US underperform the S&P 500.

Why am I going on about this?…because the character trait that makes any of us able to enter a buy order, our strong conviction that we know more than the other guy, is the same characteristic that stands in our way when we’re trying to figure out whether we’ve made a mistake.

The hard part is recognizing a mistake

The important issue for an investor is not how to fix a mistake–that’s easy: you sell the stock, you make your portfolio look more like the index.  The really key issue is how to recognize that you’re making one (before you’ve lost half your money).

Three posts on this topic

I’m going to write about this topic in three posts:  this one contains general comments; the other two will be what techniques a value investor typically uses and what techniques his growth counterpart employs.

Luckily, we’re not baseball players

Yes, investing is a lot like baseball–both experience-intensive craft skills.  But when it’s the baseball player’s turn at bat, he has to go up to the plate and swing, whether the pitcher is an All Star who never gives up a hit, or a rookie who can’t get anybody out and is just about to be sent back to the minor leagues for more seasoning.

We don’t.  We have the luxury of picking the pitchers we want to face.  We can sit on the bench and eat sunflower seeds until we see one we like.  Brokers may encourage us to transact, because that’s how they make their money, but we don’t have to.

One of the most important things I think any investor has to learn is that he doesn’t have to have a opinion about everything–and express that opinion in buying and selling.  This is a recipe for failure.

A few things we know a lot about, not a lot of things we know a little about

We should be just the opposite.  We need to have a few well-reasoned and well-researched ideas that lead us to stocks/mutual funds/ ETFs that we conclude are worth more than the market now realizes.  It’s better to have one or two things that we know a lot about than it is to have two dozen half-baked ideas.

First, create a safety net

There a number of basic investment planning steps you can take that, among other things, will help you detect where one of your investment ideas may be going wrong.  You should:

1.  have a plan and write it down–a “strategy,” if you will.  If you document your reasoning and your expectations, it’s easier to compare the outcome with them.  See my posts on Constructing a Portfolio.

2.  in your planning, establish maximum position sizes, based on your risk tolerance.  Keep to them when implementing your plan.  This will ensure you don’t put all your eggs in one basket.  Again, see Constructing a Portfolio.

3.  Monitor your performance, position by position, regularly.  This will prevent your eyes from “accidentally” skipping over the clunkers in your portfolio.  See my posts on Measuring Performance.

4.  especially for positions that may not be performing as you expect, watch how they are doing against peers (for a stock, Google Finance seems to me to have the best peer groupings).  Look at performance on very sharply up days and on down days.  If the position is weak relative to the market on both sorts of days, that’s usually a strong indication of trouble.  See my post on Down Days.

5.  know yourself.  Everyone has different strengths and weaknesses.  Over time, you’ll see that there are some arenas, say technology or the consumer, where you’ll do well, and others, say, biotech, where you will have little success.  Or it might be that you’re comfortable with larger capitalization stocks and not so much with smaller, riskier issues.

The first sign of impending trouble will be when you venture into areas where you have not been successful in the past.  I’m not saying don’t do this.  How else will you learn?   But you will want to have a small position size and the willingness to make a fast exit, if need be.

That’s it for today.  In my next posts, I’ll deal with how value investors and how growth investors typically find and deal with mistakes.