Investing consists of decision making under uncertainty. We try to purchase assets at valuations that we believe are attractive, based on our expectations of the future. We do so in the hope that the assets we purchase will generate a better risk adjusted return than the market as a whole.
There will inevitably be bad outcomes (as defined below) from our investment decisions. However, it is important to realise that bad outcomes and bad decisions are two different things. A loss making investment may not be the result of a bad decision, and bad investment decisions may not result in a bad outcome.
Our portfolio has several loss making investments. However most of them, we still feel, are not the result of bad decisions. (“We’re not wrong, the market is!”) We have, however, identified what we believe to be our first bad investment decision, and hence wanted to write about our process for dealing with bad outcomes and how we distinguish between when we are wrong and when we are unlucky.
Defining Terms
To us, a bad investment decision occurs when there is a flaw in our investment process. Such a decision does not reflect reality, and hence does not give us the stacked odds of a good outcome that we seek. This could be due to
Poor due diligence leading to insufficient information collection.
Low quality reasoning of the information gathered.
The decision being made for non rational reasons,(such as the ego).
A material change in facts after making an investment which were missed when monitoring the investment.
A good investment outcome is one that generates a better return than alternatives, adjusted for the risk taken. A loss making investment could be a good outcome if it loses less money than the market as a whole. Conversely, a bad investment outcome is one that underperforms the market. Since we must also factor in the opportunity cost of capital, a profitable investment that is less profitable than the market average is also a bad investment outcome.
While there will obviously be a correlation between a good investment decision and a good investment outcome, the presence of unpredictability creates a lot of chaos:
Good Luck | Bad Luck | |
Good Decision | Good Outcome | Bad Outcome |
Bad Decision | Good Outcome | Bad Outcome |
Why Bother?
As a side note, a pertinent question when studying the above table arises: Why Bother?
Making correct investment decisions takes enormous effort to gather and correctly digest information. Once made, investments require close monitoring and further effort in updating one’s view as new information presents itself. If you can cut corners, make a poor quality decision and still have a good outcome, why bother with all this effort?
The reason is that putting in the effort to make correct decisions will have two impacts:
It increases the probability of a good outcome.
It reduces the damage from a bad outcome and/or increases the reward from good luck (i.e: Your convexity will be higher).
These two impacts, over the long term, will lead to significant outperformance for an investor who does the work. Over time, as long as you size your bets correctly, luck averages out and results reflect good investment decisions.
Dealing With Bad Decisions
“If you can keep your head when all about you
Are losing their and blaming it on you” - If, Rudyard Kipling
If, on re-evaluation, an investment has been identified as a bad decision there are two critical actions to be taken. These should be taken regardless of whether the decision has led to a good or a bad outcome.
Firstly, damage control. You have to decide if you want to immediately take the loss and recover what capital is left, or wait for a better opportunity to exit the investment. Personally I bias to immediate recovery of funds, with the only possible limitation being low market liquidity.
It is a very common psychological flaw to hold on to an investment in the hope its value might recover. This is a dangerous way of thinking. The market does not care what your entry point was. If your thesis no longer holds, the investment could go anywhere, including to zero and the odds are no longer stacked in your favour. There is also a significant opportunity cost in holding investments given you could otherwise deploy funds into other higher conviction opportunities. Hence I strongly encourage an investor with an investment he no longer has conviction on, to take the loss and move funds into higher conviction positions.
Secondly, we must conduct a postmortem to learn from the mistake. Postmortems are a vital part of the investment process. Mistakes will happen, and should at least be converted into expensive lessons via a good post mortem process. Investors should understand why the mistake was made, and attempt to put in place controls to prevent a repeat. This leads to a strong knowledge compounding effect over time and is a key part of becoming a better decision maker.
Dealing With Bad Outcomes From Good Decisions
“If you can trust yourself when all men doubt you,
But make allowance for their doubting too” - If, Rudyard Kipling
If, upon careful evaluation you are sure that an investment, while having a bad outcome, is not actually the result of a poor decision, then you should consider continuing to hold or even increase exposure. If you liked an investment at $100, and it has reduced to $75, then it is, in theory, more attractive. This is a very slippery slope and has led to many ruined investors. Hence strict risk management is still important, and at a certain level of capital sunk in, an investor should freeze buying regardless of conviction. This is important, as no matter how confident you are, you could still be wrong or have a bad outcome.
Identifying Mistakes
As discussed above, a bad outcome should be dealt with very differently compared to an identified investment mistake. Hence one of the most important functions of managing a portfolio is in separating the good decisions that are temporarily having a bad outcome from the investment mistakes that could sour further.
To do this, an investor must be completely focused on investments with bad outcomes. They should receive significantly more attention than the better performing investments. Such investments should be constantly re-evaluated, with as much information gathered as possible in order to be comfortable about the quality of the decision and expected future outcome. In short, you must be even more convicted about the investments showing a bad outcome than the investments showing a good outcome. Reality diverging from your thesis, as demonstrated by share price underperformance is a significant warning sign that should not be ignored.
What about Good Outcomes?
“If you can meet with Triumph and Disaster,
And treat those two imposters just the same” - If, Rudyard Kipling
A lot of the above concepts can be inverted in order to explain how one should deal with good investment outcomes:
Don’t assume an investment is profitable because you made a good decision. You could have made a bad decision and just got lucky.
You should re-evaluate your thesis regularly even for profitable investments. They could still be mistakes or the underlying facts may have changed. If so the framework for dealing with mistakes would still apply in exactly the same way.
Post Mortems on good decisions are a helpful way to understand what works and what you should do more of.
The most important thing is to remain humble despite good outcomes. You could be doing well because you are lucky, not because you are making good decisions. Similarly periods of good investment results often affect an investor's ego, leading to overconfidence and careless risk taking with less diligence than before. This common phenomenon often leads to well performing investors blowing up later in their careers.
To Conclude,
A good investment outcome is an investment that outperforms alternative investment options. A bad investment outcome is one that underperforms alternatives. This is regardless of whether you make or lose money.
Bad outcomes aren’t always mistakes, you could just be unlucky.
Good outcomes may be due to good luck, and not good decision making.
Regardless of whether an investment is showing a good or bad outcome, it should be regularly re-evaluated to see if your thesis still stands, or if reality is different from your expectations.
Investments showing a bad outcome are more likely to be the result of bad decisions, and hence should be monitored with special attention.
If you realise that an investment is a mistake, the best course of action is usually to take the loss and exit.
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