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Investing: Learn from your mistakes - Views on News from Equitymaster
 
 
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  • Aug 31, 2009

    Investing: Learn from your mistakes

    Investing is a knowledge intensive activity. Being a successful investor requires life long acquisition of knowledge, i.e. learning. Especially learning from one's own mistakes. But it is easier said than done. We often fail to admit that we have made a mistake, let alone learn from it. Why is it so? How can we correct this tendency? We shall examine these issues in this article.

    Why we are blind to our mistakes
    There are at least four behavioral stumbling blocks why we fail to recognize our own mistakes. They are self-attribution bias, hindsight bias, the illusion of control and feedback distortion.

    Self attribution bias is the tendency to attributing all our positive results to our own skill and the bad outcomes to bad luck. Hindsight bias is the tendency to believe after an event has taken place that we knew all along that it would take place. The illusion of control is the tendency to ascribe results to our actions when in fact, they are caused by other reasons. Feedback distortion is the tendency to twist facts to fit our beliefs. Or as Charles Munger, Vice Chairman of Berkshire Hathaway puts it, "torturing reality so that it fits our mental models of the world".

    How to rectify this tendency?

    1. Admit: The first step in dealing with biases is to admit their presence.

    2. Keep records: Writing down one's decisions and the reasoning behind them helps keep a check against self-attribution bias. It also helps counter the hindsight bias, especially if one has written down the various alternative results possible. In fact, even Warren Buffett recommends this method. He says, "Write down the reason you are buying a stock before your purchase. Write down 'I am buying Microsoft @ US $300 bn because...' Force yourself to write this down. It clarifies your mind and discipline. This exercise makes you more rational."

    3. Check if you are really in control: The illusion of control is particularly strong when there are lots of choices (like lottery tickets), there is a large amount of information (relevant or irrelevant) and there is personal involvement. In investment, the equivalents of these factors are large portfolios, high turnover and short time horizons. Hence, the most effective remedy for the illusion of control is long term investing in select stocks.

    4. Seek the bad news: We should create mechanisms at the personal and the organizational level that records and speeds up the delivery of bad news. The exact opposite of 'shooting the messenger'. When we check for results, we should actively look for negative outcomes, instead of only seeking positive results.

     

     

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