Making an investment mistake is not as bad as it seems

Embrace them as valuable lessons that mould you into a savvier investor

MOST people talk about their wins but not their losses. However, even the best investors make mistakes.

Take Warren Buffett, for example. Widely regarded as one of the greatest investors, he has openly admitted to his share of errors.

So, what constitutes a mistake?

In my view, it is a stock that has been held for five years – or more – which still yields a negative total return after factoring in dividends. Because that means one has lost money, even after reinvesting all the dividends received over that period of time.

Why five years?

It’s a long enough time frame for a business to demonstrate substantial growth in revenue and profits.

What do you do if a mistake has been made?

For starters, it is important to remain composed. Mistakes serve not only to refine your investment skills but also to impart valuable lessons on how you can do better in the future.

Refining your criteria

If you find yourself consistently buying the wrong stocks, it is time to consider looking at your investment criteria.

When I started investing in 2005, I purchased shares of hot favourites such as Ezra and Swiber, as the oil and gas industry was booming.

With the wind at their backs, it felt like a sure bet for the shares to skyrocket in value.

Little did I know that both companies were on a debt-fuelled growth binge that was bound to backfire.

For the record, Swiber filed for liquidation in July 2016 after incurring hundreds of millions of dollars in debt while Ezra filed for bankruptcy protection in the US a year later.

Thankfully, I came to my senses and sold before the carnage.

Although I escaped unscathed, those missteps taught me to look for companies with steady free cash flow.

I have since grown as an investor, thanks to the lessons learnt from those early blunders.

Also, I realised that it is important to flip the script. Rather than beating yourself up over mistakes, embrace them as invaluable learning opportunities.

Unknown unknowns

It is important to acknowledge that mistakes can stem from factors beyond our control as life is full of surprises, influenced by countless unpredictable events.

Similarly, in investing, brace yourself for unforeseen circumstances that may disrupt your original strategy.

Even if you are thorough with your risk analysis, there are “unknown unknowns” that can emerge unexpectedly. For example, natural disasters such as earthquakes, tsunamis, or the recent Covid-19 pandemic.

Beyond nature’s curveballs, technological leaps can also upend your investment assumptions – imagine a new product stealing the spotlight, rendering its predecessor obsolete overnight.

If one has invested in the older version of the product, a sharp downturn in sales and profits is to be expected.

Such events are inherent risks in investing, impossible to completely foresee. No matter how much research has been done prior to making the investment, there is always a chance of an unexpected setback.

These surprises are tricky to mitigate and often catch you off guard.

Don’t be too hard on yourself

Curious about an acceptable error rate? Just consult Peter Lynch.

The former manager of Fidelity’s Magellan Fund boasted an impressive 13-year run, averaging a stunning 29 per cent annual return, and outperforming the S&P 500 Index nearly every year.

According to Lynch, aiming for a 90 per cent success rate is close to impossible. In his view, you are considered a good investor if you can get six out of 10 investments right.

So, if a seasoned fund manager such as Lynch suggests that a 60 per cent accuracy rate is respectable, investors should not dwell too much on occasional slip-ups.

Errors are not just inevitable; they are evidence that perfection is unattainable.

The key? Ease up on yourself when mistakes happen and assess their impact on your portfolio. Because they do not carry the same financial weight.

Losing 90 per cent on a $1,000 investment hurts, but it is manageable. However, a 10 per cent loss on a $100,000 position means a $10,000 hit.

This example highlights that the percentage of loss isn’t everything. What matters more is the actual dollar amount at stake.

And this calculation ties directly to how much capital you allocate to each position in your portfolio.

Winning big, losing small

Imagine you have a straightforward portfolio: 10 positions, each with a $1,000 investment, totalling $10,000.

Over five years, one stock plunges by 90 per cent, while another skyrockets 10 times from its original price.

Applying Lynch’s 60 per cent winning ratio, let’s say another five stocks enjoy a 20 per cent increase while three dip by roughly 20 per cent.

Crunch the numbers, and you’ll find the four losers now amount to $2,500 (that’s $100 plus $2,400), representing a 37.5 per cent drop from their starting value of $4,000 (four stocks times $1,000).

On the winning side, the six stocks tally up to $16,000 (that’s $10,000 plus $6,000), soaring almost 167 per cent above their initial S$6,000.

Check out the table for a clear breakdown of this scenario. Illustrating the impact of mistakes

Stock	Cost ($)	Market Value	Remarks
Total	10,000	18,500
1	1,000	100	Lost 90%
2	1,000	800	Lost 20%
3	1,000	800	Lost 20%
4	1,000	800	Lost 20%
5	1,000	1,200	Gain 20%
6	1,000	1,200	Gain 20%
7	1,000	1,200	Gain 20%
8	1,000	1,200	Gain 20%
9	1,000	1,200	Gain 20%
10	1,000	10,000	Gain 1000%

Even with four stocks in the red, your portfolio still boasts an impressive 85 per cent overall gain after five years.

That translates to an impressive compound annual growth rate of 13.1 per cent.

This example demonstrates how capital-allocation decisions impact investment returns.

If you had identified a potential winner and allocated a larger portion of your capital to it, your winners would have outweighed your losers by a significant margin.

By sizing your positions based on a favourable risk-reward ratio, you ensure big wins and minimal losses.

Keep in mind – while a stock’s price can soar indefinitely with rising profits, your potential loss is capped at 100 per cent.

This fundamental truth works in your favour: Allowing your successful investments to flourish over years or even decades can easily offset any occasional missteps.

Get smart: Don’t be afraid to make mistakes

Investing without making mistakes is like trying to surf the ocean waves without getting wet – it’s just not realistic.

Instead of dreading errors, embrace them as valuable lessons that mould you into a savvier investor.

An alternative is to avoid investing altogether and to park all your money in a capital-guaranteed fixed deposit or bank account. However, this option is almost guaranteed to lose you money through inflation. Acknowledge that mistakes are par for the course, all the while fine-tuning your investment strategy.

Make sure these missteps amount to mere hiccups while allowing your successful investments to snowball into substantial profits.

This approach not only hones your investing prowess but also delivers commendable results over time.

The writer does not own shares in any of the companies mentioned. He is portfolio manager of The Smart Investor, a website that aims to help people invest wisely by providing investor education, stock commentary and market coverage.

Article taken from The Business Times by Royston Yang