Understanding Investing Mistakes
Board: Pro Philosophy and Strategy
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I think most of us have probably done pretty well in this great bull run of recent years. Pro itself has had a market-beating 5 years despite its hedges and ample cash, which is genuinely impressive (kudos again to the team!). But I still think it's important to look for patterns of mistakes in my own investing and to try to get to the bottom of them, and I've been doing a round of that over the past few weeks.
I've noticed a definite pattern that arises again and again in my sub-optimal decisions over the past few years: choosing to get out of successful businesses due to some concern or another (competition, threat of disruption, management decisions I disagree with, unreasonable pricing, a dislike of their product or service, etc.) -- often after a large jump in the stock price. My concerns about the business lead to a feeling that the stock has gotten ahead of itself, and I end up capping my gains by taking action to protect them.
Ironically, I've become a big believer in letting my winners run, and I've learned lessons about things like letting my tastes as a consumer rule my investment decisions. But nevertheless, my trading history over the past few years tells a different story: though I talk the talk, I'm clearly not walking the walk as much as I thought I was.
So I've been mulling it over and trying to get to the real reasons behind why I do these things, and I was reminded of a blog post I read last year from venture capitalist Paul Graham. I went back and re-read it a few days ago, and a lot of things finally clicked. Even though we're not investing in startups here in Pro, I think many of Graham's observations apply to investing in general and I wanted to share a few that finally hit me (I've added some bolding):
The total value of the companies we've funded is around 10 billion, give or take a few. But just two companies, Dropbox and Airbnb, account for about three quarters of it.
In startups, the big winners are big to a degree that violates our expectations about variation. I don't know whether these expectations are innate or learned, but whatever the cause, we are just not prepared for the 1000x variation in outcomes that one finds in startup investing.
While the returns are certainly more extreme in startup investing, the general principle nevertheless applies to my own portfolio as well: despite having a number of successful investments, my long-term returns are mostly driven by just a few companies. Without crunching the numbers, I suspect the same is true of Pro to some extent: there's a lot of green on the scorecard, but only a few positions with genuinely outsized, portfolio-driving returns.
As an investor, I am simply not prepared for the magnitude of the gains in a genuine winner -- they defy my expectations of what is reasonable, especially when those gains rack up quickly and the stock just goes up and up and up. The price appears unsustainable given the situation today, and so the rational thing is to try to protect those gains. That's especially true when there are a lot of legitimate concerns about the business, and that leads to another observation:
[T]he best startup ideas seem at first like bad ideas. I've written about this before: if a good idea were obviously good, someone else would already have done it. So the most successful founders tend to work on ideas that few beside them realize are good. Which is not that far from a description of insanity, till you reach the point where you see results.
The first time Peter Thiel spoke at [our company] he drew a Venn diagram that illustrates the situation perfectly. He drew two intersecting circles, one labelled "seems like a bad idea" and the other "is a good idea." The intersection is the sweet spot for startups …
History tends to get rewritten by big successes, so that in retrospect it seems obvious they were going to make it big. For that reason one of my most valuable memories is how lame Facebook sounded to me when I first heard about it. A site for college students to waste time? It seemed the perfect bad idea: a site (1) for a niche market (2) with no money (3) to do something that didn't matter.
There's no such thing as a perfect investment. Every business faces challenges and threats, leading to numerous legitimate concerns for us as investors. I realize now that I focus too much on those concerns, ignoring the Darwinism at work: great businesses that demonstrate an ability to be repeatedly successful are that way for a reason and are likely to remain successful despite my concerns about the business model, or the management, or the product, or the competition, or the other challenges they face. Even the best new business ideas may sound bad and raise a lot of legitimate questions. My concerns are completely rational but, in light of the company's demonstrated success, they're likely to represent tail risks and I'm doing my portfolio a disservice by letting them rule my investing decisions.
I can lay out what I know to be the right thing to do, and still not do it. I can make up all sorts of plausible justifications. It would hurt [our company's] brand (at least among the innumerate) if we invested in huge numbers of risky startups that flamed out. It might dilute the value of the alumni network. Perhaps most convincingly, it would be demoralizing for us to be up to our chins in failure all the time. But I know the real reason we're so conservative is that we just haven't assimilated the fact of 1000x variation in returns.
We know that studies have shown that humans feel far more pain losing some amount of money than they feel pleasure gaining that same amount of money. We have a natural bias towards protecting what we have, and I'm sure that's doubly true when our gains seem unreasonable in light of the current business or market or economic environment. And of course not all our winners will stay winners -- there are plenty of horror stories that give us a reason to protect those gains! -- but, if anything, that makes it even more important to let our true successes deliver the outsized returns that will more than make up for everything else and drive our portfolio for years or decades to come. The worst thing we can do is cut the truly successful investments off at the knees and leave our portfolio at the mercy of the mediocre.
To succeed in a domain that violates your intuitions, you need to be able to turn them off the way a pilot does when flying through clouds. You need to do what you know intellectually to be right, even though it feels wrong.
Looking back at my less optimal decisions over the past few years, I can clearly see that every one of them made me feel better. Some even looked smart in the short term. But now enough time has passed to clearly reveal them as long-term mistakes. And that leads to a final point:
You not only have to solve this hard problem, but you have to do it with no indication of whether you're succeeding. When you pick a big winner, you won't know it for two years.
Meanwhile, the one thing you can measure is dangerously misleading. The one thing we can track precisely is how well the startups in each batch do at fundraising after Demo Day. But we know that's the wrong metric. There's no correlation between the percentage of startups that raise money and the metric that does matter financially, whether that batch of startups contains a big winner or not.
One of the hardest parts about investing is that we usually don't know if we're doing the right thing or not for many years -- and, worse, the short-term results of our decision have nothing to do with the long-term results. It's so easy to sell a high-flying stock that seems clearly ahead of itself and pat ourselves on the back when it drops. But how does that decision look 3, 5, or 10 years down the road? How much wealth did we leave on the table? If we optimize our investment decisions around short-term results, we're optimizing the wrong thing and our portfolio is likely to suffer as a result.
There's also a practical consideration: we're either good at picking winners or we're not. If we're good, then we've likely chosen winning investments and should obviously hold onto them for the long term. And if we're bad at picking them, then why sell the few winners we stumbled into and force ourselves to try to pick new ones with that capital instead? Either way, sticking with our winning investments makes sense.
So here are the key insights that I will be working to apply to my own investing in the future:
(1) Despite experiencing some real winners, I nevertheless remain unprepared for the magnitude of gains that come from such an investment. They will seem like too much -- or too much too quickly -- and my natural bias will be to protect them, justified by my rational concerns about the business. That's a long-term mistake. In reality, I should be adding to these winners. **
(2) Even the best companies with a track record of repeatable success are surrounded by legitimate and rational concerns and doubts, and it's easy for me to give in to that -- especially in light of #1 when I see the stock soaring and believe my potential reward is diminishing relative to my perceived risk. But these companies have already proven their ability to succeed, and it's likely that the risks I perceive are less material in reality. The best thing is to let my portfolio benefit from the investment's continued success.
For those interested in reading Graham's full blog post, it's at:
** If you accept the idea that investors are simply unprepared for the magnitude of gains from a genuine winner, then David Gardner's more controversial criteria for his Rule Breaker service that a company be "grossly overvalued according to the financial media" suddenly makes sense when on the hunt for these types of companies.