Lucky, or good?

One of the hardest things to do well, especially as an investor, is to learn from our mistakes.

When we pick an investment that does well, it’s easy to think about it, analyze it, dwell on how smart we are. But, when an investment goes against us, it can be very tempting to put those losses into our mental dustbin and try to forget them.

This temptation really should be resisted, because learning from our mistakes is more important than celebrating our victories.

Just as important, and more often overlooked, is that we should examine critically our successes, too. Sometimes good outcomes are due to luck and not skill. We need to understand which occurred to improve our results over time.

I like to look just as hard at my failures and my successes, because learning from both can reveal powerful lessons that can be applied in the future. I’ve found this can lead to much better investment results over time.

There are several questions I ask myself with both successes and mistakes:

  1. What happened at the underlying business in terms of fundamentals?
  2. What happened to the market price and valuation with respect to those fundamentals?
  3. Was I lucky, or good?

(I ask more questions than this, but these are the most important ones.)

When I invest, I do it based on certain assumptions about underlying growth in sales or book value and underlying margins or returns on equity. My first question is to figure out how far off I was in evaluating those underlying fundamentals. Did the company grow faster or slower than I expected? Were the margins higher or lower? What led to those outcomes and how was that different than my expectation?

My first question is about the underlying company separate from the market’s reaction to it. The second question is about how the market reacted to those fundamentals. Sometimes a company does worse than you think it will, but the market’s opinion becomes more favorable than you thought it would. Sometimes a company does better than expected, but the market’s opinion about the business becomes worse.  

The answers to the first two questions helps me answer the third question: was I lucky or good? When a company does much worse than I expect, but the market’s opinion about the company improves, that’s more lucky than good. When a company does much better than expected, but the market’s opinion sours, that’s unlucky.  

It’s very important to differentiate between luck and skill with investing. If you’ve been lucky and don’t identify it as such, you’re likely to repeat that process and see your luck run out. I had a lot of success buying technology companies from 1996-2000 each time prices pulled back temporarily.  That success was more luck than skill, and I ended up paying the price later when that strategy no longer worked.  

It’s also important to differentiate between bad luck and bad skill. If you pick a company that does well, but sell it because the market’s opinion of the company worsens over time, you will likely miss large future gains. A good process may lead to bad results occasionally, but that’s a bad reason to give up on the good process.

Learning from mistakes can be very time consuming, and that puts many people off. You have to go back and look at historical fundamentals over time, you have to look at how the market reacts to those fundamentals, you have to adjust for temporary changes like recessions or transitional industry dynamics, you have to keep track of your initial expectations and how they changed over time. It’s not simply a matter of looking at your returns in a vacuum, but of evaluating your results relative to your expectations, market reactions and alternative options.

I believe the effort is well worth it, though. When you realize you had good luck instead of good skill, you can prevent that process from happening in the future. If you realize you’ve been unlucky and not unskillful, you can keep that process in place to profit when the odds turn your way. 

No one relishes examining bone-head mistakes in detail, or realizing one’s brilliant outcome was luck instead of skill. But if you like improving results over time, the effort is well worth it.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Lucky, or good?

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