Low Risk Rules

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You will be wrong. Choose your mistakes.

Successful long-term investing is about finding future winners and holding on through the inevitable ups and downs.

But nobody bats 1.000. It’s also about identifying mistakes as early as possible, and course correcting as necessary. It can be hard to swallow your pride and admit a mistake, but averaging down into a losing position is perhaps the worst and most common error that the value investor commits.

As such, investing requires a unique combination of confidence (believing you’re right when everyone else is wrong) and humility (acknowledging when you’ve made a mistake).

You will be wrong, often

If investing were a game of binary outcomes, you would only need to be right 51% of the time to make money over the long term. That doesn’t sound so bad! But professional traders will tell you that if you manage a position intelligently, you can be right far less than half the time and still do well, as long as you cut your losers early and let your winners run. Indeed, many successful traders will admit that they are correct less than half the time.

You’re going to be wrong. A lot. The financial cost of being wrong is an investment loss that appears on your income statement. But the best investors will take lessons that will reduce their odds of being wrong in the future. Now we can stop thinking about being wrong as an expense, and start thinking about it as an investment.

Choose your mistakes

Realizing that you will be wrong, the next challenge becomes choosing the mistakes you’re willing to make. I write this from experience, because a quarter century of investment experience has allowed me to make some big mistakes.

If I’m wrong on a high probability bet, I can live with it. I know that I made the right decision at the time, based on the information I had.

I’m willing to tolerate a loss on a large, profitable blue chip if I’m playing the odds that the challenges facing the company are temporary. The key, of course, if you’re wrong, is admitting your mistake and taking the loss quickly, rather than riding a value trap down for years (yes, I know, that’s easier said than done).

Betting on long shots is an entirely different matter. You are now going into it knowing that you will probably lose. The odds are stacked against you before you have even started. In order for this bet to have a positive expected value, the payoff has to be big.

I’ll feel like a dummy if I lose a bet on an unprofitable company with an untested business model and a green management team. I’ll tell myself “I should have known.” There’s not much to learn from the experience, other than not to do that again.

Speaking of “I should have known,” it’s hard to accept a loss on a company trading at a stratospheric multiple that depends on tremendous growth projections. Even the smallest hint of a shortfall from those optimistic investor expectations will result in a swift, sharp loss. And if the company fails to deliver for a few quarters in a row, look out below, as investor expectations are recalibrated. The majority of your investment can vanish in a flash. Betting successfully on these situations requires heroic growth.

Turnarounds are the bane of the value investor. It can be painful to wait for positive signs that never materialize. When bankruptcy is a possible outcome, equity can get zeroed out. With no floor, it’s a mistake that stings badly.

These experiences have kept me away from cryptocurrencies, or other digital assets with no intrinsic value (in fact, no value at all other than the idea that other people want to own it, only because it’s going up in price). Because if sentiment sours, there is literally no floor to the price. Zero becomes a real possibility.

But it doesn’t have to be a crazy speculation. This weekend, Canada’s Globe and Mail featured a writeup on private debt funds, which were marketed as “safe” income generating assets to conservative investors. These funds aren’t zeros, but imagine the frustration of being unable to sell an investment you purchased for yield… while that yield has been cut down by more than half.

You’re going to be wrong.

Choose your mistakes wisely.