Behavioral Finance

Silver Linings

Everyone makes mistakes in their portfolio. The best investors embrace their foibles and learn from them.

Your investments won't always win, but the chance to learn from your mistakes is a big silver lining. Photo by Elisabeth Dellinger

Last Friday, The Wall Street Journal ran a piece that we're pretty sure will make just about every reader feel better about themselves: true confessions from some Wall Street bigwigs on the best and worst investments they ever made. They aren't all market related, of course-some fondly recall their collegiate years and sweetheart meet-cutes-and few if any normal people can really learn from Dolly Parton's investment in Dollywood. Others, like the anecdotes from passive investing stalwarts, have a clear bias that we'd advise taking with a grain of salt (see this and this for more). But in between are stories of some gigantic hits and misses-and valuable lessons. Everyone makes mistakes, even the best of the best. Believe it or not, that's good news! Recognizing and learning from your mistakes can help you reduce your error rate over time, making you a better investor.

This is easier said than done. In real life, we learn from our mistakes all the time, starting from childhood. If you touch a scalding pan and get a nasty burn, you learn to use potholders. If you eat too much raw cookie dough and get sick, you learn to avoid raw eggs and an abundance of sweets. If you catch a cold in winter because you went out without a coat, you learn to bundle up. This is how we all grow, adapt and become better at the game of life.[i]

In investing, though, it's harder to learn from errors. That section of our brain is just programmed differently. As humans, when our investing decisions don't work out, our brains are hard-wired to do anything but take stock and teach ourselves a lesson. How so? We hate losses, so we shun regret! Prospect Theory tells us humans tend to hate losses about two and a half times harder than we enjoy equivalent gains, and we will do just about anything to avoid that pain. For some, that means simply hanging on to a losing investment in hopes it will rebound and spare them the pain of selling at a loss-without giving one single thought to why the stock is falling and whether a recovery is at all likely or what other, better opportunities they might miss in the meantime. For others, it means absolving themselves of any and all blame for a bad decision. If Jim or Judy's[ii] mutual fund goes down, it isn't their fault-it's the fund manager's! And it isn't their fault they picked that fund manager, no siree bob. It's the fund ranking website's fault! Or the marketing materials' fault! Or their broker's fault for recommending it! Ditto if we're talking individual stocks. Or it's the analyst's fault for issuing a clearly bogus "buy" rating. Or the CEO's fault for setting too-high expectations. Anyone, anyone's fault but Jim or Judy's.

This might make you feel better in the short term. Shifting blame lets you feel innocent, making losses less painful! But it does you no favors. Mistakes are valuable, but only if you recognize them and take the time to study and learn from them. If your stock picks aren't working out, instead of blaming others or hanging on blindly out of sheer hope, think about why you owned the stock in the first place. Was it a good, forward-looking reason, like having solid growth potential and dominant market share? Or were you caught up in things like recent past performance? If your decision-making was sound, and things just didn't work out, that happens-maybe a new competitor stole that company's thunder, and your investment thesis didn't hold true. Even sound investment theses don't always win out! Can't win 'em all. But if it turns out you used suspect criteria, like past performance, "hot tips" that you never looked into, industry analysts' "buy" ratings that you never looked into or anything in that vein, then that's a good opportunity to learn the inherent perils and take a different, wiser approach the next time. Ditto for when you're picking which categories (sector, country, size or style) to emphasize. Or which funds to own, if you're into funds.

To see this in practice, let's look at some of the examples from that Wall Street Journal piece. Like, for instance, the finance professor who thought he spied a property bubble in Japan in 1989, bought put warrants on Japanese stocks a year before they started falling, racking up losses as the Nikkei rose, and then sold shortly after Japan's decline began-locking in big losses and missing the potential for astounding gains as Japan continued sliding, all because of an emotional reaction. His takeaway: "Though I lost money, this was a valuable investment. I learned that I couldn't time markets and that a bet that eventually pays off doesn't do you any good if you can't afford to stick with it." Truer words have rarely been spoken.

Or, consider the famous activist investor who decided to plop his entire portfolio into a single medical device stock, which promptly tanked after its products were linked with several users' deaths: "In the years it took to remake my lost profits, I had a lot of time to absorb the important lesson of not overconcentrating positions." A well-known author and TV personality learned a similarly timeless lesson: "When you have a low-priced stock, don't think to yourself, 'How much more can I lose?' You can still lose everything from a lower dollar level." Past performance, folks, isn't predictive-a lesson underscored by a businessman who learned, the hard way, not to chase hot trends.

Mistakes are painful. No one likes making them, and the losses hurt! But every cloud has a silver lining, and learning opportunities are a big silver lining when investing decisions don't work out. See them for what they are, and don't let your brain trick you out of the chance to make yourself better. Investment mistakes might not be profitable, but investing time and energy in learning can pay dividends in the long run.

Stock Market Outlook

Like what you read? Interested in market analysis for your portfolio? Why not download our in-depth analysis of current investing conditions and our forecast for the period ahead. Our latest report looks at key stock market drivers including market, political, and economic factors. Click Here for More!

[i] Not to be confused with the game of Life. Though that has some valuable lessons, too!

[ii] Randomly selected names, brought to you by the letter J.

If you would like to contact the editors responsible for this article, please click here.

*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.