One of my first bosses used to say that it takes three good stocks to offset the negative effects of one clunker. Today, I’m not sure that’s the right ratio–a lot depends on investment style. Also, I think the number is bigger than that in bear markets, where bad news is discounted heavily and good news is ignored, and smaller in bull markets. But the ratio is certainly greater than 1 at all times. That’s why it’s catching mistakes early is crucial to investment success.
Recently I’ve been reading books on decision-making. I got the first, Jonah Lehrer’s How We Decide, from one of my sons. I saw a review of the second, The Art of Choosing, by Sheena Iyengar, and bought it myself. Both cover a lot of the same material, and in the same order. This may be due to the Columbia connection between the authors. Lehrer was an undergraduate there; Iyengar teaches there. How We Decide is more readable and refers to a much larger number of experimental results. The Art of Choosing focuses more on research Ms. Iyengar has done herself, and emphasizes that the psychological picture we create of ourselves for ourselves will be internally consistent–but won’t always correspond with reality.
Both books highlight the fact that we all tend to hold beliefs that we come to on a non-scientific basis. For example, we all tend to think that we’re above average at just about everything we do. Once we’ve made a decision, we tend to defend it by searching only for information that reinforces our opinion. We also tend to ignore or screen out any data that calls our initial decision into question. In fact, if we have believed something different in the past, we also gradually rewrite our memories (shades of Orwell) so that we come to believe we’ve always thought what we think now.
Even worse than all this, the more important the initial belief, the more likely we are to do this.
While this tendency may be relatively harmless if I think I’m handsome or witty or a good dancer, it’s an absolute disaster for an investor. It’s a very great difficulty for professionals, who need very strong egos to withstand two aspects of the job: many of the economic factors that influence the portfolio are outside the manager’s control, and at least 40% of the decisions managers make turn out to be wrong.
The professional manager has to keep his confidence from shattering, but at the same time be open enough to reality to stop his mistakes from destroying his portfolio performance.
How do you do this?
You have to be aware of the tendency to need to be right all the time, and resist it. You have to actively scan news sources to look for negative information about your investment ideas. A professional has to make it clear to sellers of research that you don’t regard a negative opinion or negative information as insulting or a reason to stop associating with them.
In my experience, every portfolio has its dark corners where underperforming stocks fester. Periodic performance measurement and stock-by-stock attribution analysis are the only cures.
Some investors–I’m not one of them–will also have mechanical rules that compel them to immediately sell a stock if, for example, it drops by 15% from its purchase price or earnings results fall short of internal/external analysts’ estimates. The first rule seems to me to work better for value investors than their growth counterparts. The second appeals to me more, but–at the risk of succumbing to the self-deception I’m writing about–I don’t subscribe to it. My issue: the risk of missing an AAPL or a MON or a COH because of a temporary earnings disappointment is too high.