Investing requires a lot of conviction. Especially in equity investing where the future outcomes of any business are uncertain & many variables can affect business performance in the long run. In such a case conviction is a good currency to have.
But what is this conviction made of?
Conviction is to believe that something is right by judging the facts which we gather after going through available data. Why do we believe that something is right? Well its tricky to answer it this way. So we can try and invert the problem into thinking – why do we get things wrong? To put it into context, why do investors make mistakes?
Kathryn Schultz researches the phenomenon of ‘Being Wrong’. In her book & in her talk at TED she mentions what it feels when we are making a mistake. Does it feel horrible? Does it make us feel bad about our choice? No, while making a mistake we constantly feel we are right. All those miserable, horrible feelings come only after realizing that we have made a mistake. In most cases we can move on with our lives & forget about the mistake, but as an investor we have to pay our tuition fee.
Part of getting things wrong have been extensively discussed in behavioral finance, but which human tendency makes us feel that we can never be wrong. Error Blindness.
Errors are a natural part of the outcomes, everybody makes mistakes. But to be blind to errors is to welcome disaster at every decision. Error blindness can be a handicap for most people, sheerly because of ignorance or blatant over-confidence in our ability. Basing our investment decision on the assumption that the business we are investing in is going to grow perpetually irrespective of how the economics of the business will be over the long term, can be classified as error blindness.
Another fact that makes errors damaging is our ability to not learn from them. The moment we walk away from an error thinking it was one-off & highly unlikely to occur again, we lose our ability to learn from it. Its not advisable or enjoyable to make too many errors & later brag about the education, it’s necessary to protect ourselves from making less damaging errors. Understanding why errors are made & are they made because of a poor process or extremely high expecation from the outcomes is very important.
On a similar line of thought, as investors, how much leeway for error do we allow to the management teams of the businesses we own? It’s important because business outcomes are usually unpredictable. Estimates can go wrong, or unforseen consequences can destroy a lot of value. In such cases how do we assess that the management of our businesses have the shareholder’s best interest at heart? By studying their past actions we can make sure that the management team has a sound process in place to learn from their errors & tries to avoid as many errors as possible. That does not guarantee avoiding future mistakes, but gives a rough reference point to understand how they do what they do best. Before investing we must also pay attention to what price we are willing to pay for this business which will determine how much we stand to lose if things go seriously wrong.
Just like in life, investing also needs to have a good process in place. Whatever investment philosophy an investor follows, a robust process ensures that we use a disciplined approach to figure out the risk we take & the return we expect.