Source: Calvin & Hobbes Comic Strip
The most fascinating thing about the equity market is our ability to make mistakes, lose money, feel the sting of that loss & learn where we went wrong. Mistakes are an inevitable part of investing. They are a motivation to learn & also the best source of knowledge about ourself. The author Kathryn Schulz writes in her interesting book, Being Wrong – How does it feel when we are being wrong? It feels like we are being right up until that moment when we realize that we have made a mistake. With such a powerful mental block for identifying mistakes how can we protect ourselves from such errors of judgement?
Be Aware
The first & the most important thing we must do to protect ourselves from errors is to accept that we are prone to making errors. There is an ocean of research on behavioural finance which can equip us into understanding where & how we can go wrong. Once the realization of being prone to errors sets in, we can move on to the next step.
Be Careful & Fastidious
When we research new investing ideas, we can develop a process which will allow us to follow some basic steps in researching businesses & industries. We can use simple starting points like Annual Reports & then back it up by using scuttlebutt or doing our own investigative work on the business. We can force ourselves to use tools like excel with great care by checking & re-checking our assumptions.
Learn & Learn & Learn
Investing is all about constant learning. We can develop this habit by exposing ourselves to as many learning resources as possible. This will enable us to be informed & help us build opinions about the businesses we are studying. Like Charlie Munger says – “Work, work, work & hope to have a few insights”.
Use Portfolio theory without the mumbo jumbo
Modern portfolio theory is an interesting part of financial literature which can instantly help you to sleep if you try to read it from a finance text book. Instead we can learn to use the same principles by actually investing our money & tracking our portfolio of investments. Over a period of time, we will have a decent enough data about our own ability to take risks, track the number of stocks in our portfolio & know how much loss we can tolerate. We will also learn intuitively how much of our money we would want to invest in a single stock & learn how circumstances in different industries affect the stocks in our portfolio. We can avoid getting bored by the finance theory & yet use this simple principle to manage our portfolio better.
Use filters
Investment analysts, fund managers, etc are a good source for stock ideas. But instead of using them as a source we can use them as a filter to see how our assumptions stack up against these professional investor’s assumptions. We can be extremely positive about a particular company, but the entire investing community might be against that idea. We can use such an opportunity to test our assumptions & work our way backwards to our errors. This can also present a unique contrarian investing opportunity if we are right & the entire investing community is wrong. (it is possible).
Automate & Restrain
The entire process of habit formation relies around automation. How can we develop a habit to consistently avoid making the same mistakes? We can use tools like checklists which can have actions that we need to take before we invest into any stock. We can tweak the checklist as we become more experienced with our ability to understand our own behaviour. Checklists prove to be very effective in controlling & restraining our excitement when we come across any new investment ideas. It provides a good shield against our weak psychological defences & can protect us from our own mistakes.
Read the extensively researched & very interesting book by Charles Duhigg called The Power of Habit to learn more about how habits are formed & how they drive us.
To understand the importance of checklists, read the brilliantly written book called The Checklist Manifesto by Dr. Atul Gawande.
Mistakes happen & despite following these steps we will find new ways to amaze ourselves by making new errors. They will only make us wiser if we learn from them rather than just accepting we were wrong & ignoring them as a bad experience.
Watch this interesting TED talk by Kathryn Schulz on Being Wrong.
by Raunak Onkar