MistakesAugust 13, 2021 2023-09-25 7:09
Letter # 53
Over the past two years, did you take a few investing decisions that you now regret? Did you panic during Covid and sold a part of your portfolio? Or, bought only a little during recovery, waiting for a ‘better price’ to buy the balance and missed the rally entirely? Or started investing, but didn’t size equities high enough for those stellar returns to move the needle enough?
While the list could go on, by the end of this letter, it is my hope that you would not consider those as mistakes, for two reasons: (a) “investments” are a different field from a few other areas where being ‘right at all times” is critical; and (b) for everything that is meaningful in life, not failing enough is often a bigger failure.
First, let me borrow a story from Morgan Housel’s book ‘The Psychology of Money’. Consider what would have happened if you had invested USD1 every month from 1900 to 2019. You invest USD1 every month, no matter what. Don’t bother listening to economists or analysts–just invest. Let’s call an investor who does that Sue. But then, investing during recession is scary. So, perhaps, you don’t invest when the economy is in recession, sell everything when that happens, accumulate the cash and invest when recession ends. We will call that investor Jim. And, perhaps, you are even more conservative. You wait a few months for the recession to end and sell everything within 6 months of the beginning of recession. We shall call that investor Tom.
Given how the benefits of SIP have been engrained in our minds by the mutual fund industry, it would be intuitive to figure out that Sue wins, but can you gauge, by how much? Sue ends up with USD435k, Jim with USD257k, and Tom with USD235k. Of the 1,428 months between 1990 and 2019, 300 were marked by recession. So, in order to be richer by 85%, all that one needed to do is keep their cool for 22% of the time!
Instead, most financial advice these days is about “today”. What should you do ‘right now’; what stocks should you buy ‘right away’? There are fields where you must be perfect every single time, like flying an aircraft. There are also fields where you must be pretty good nearly all the time, like running a Michelin 3-star restaurant. But finance is not one of those fields. Robert Mercer, the co-CEO of RenTec, said this, “we are right 50.75% of the time… but we are 100% right 50.75% of the time. You can make billions that way.” And, Jim Simons, founder of RenTec, did manage to make a quarter of a trillion dollars by precisely doing that.
Second, we often don’t differentiate between: (a) the frequency; and (b) the impact of the outcome. Of the 100 decisions that one takes, one could be wrong in 90, but could still generate stellar returns. The latter depends on how big the wins are. The venture capital industry is a prime example. Nearly everything that is important in life is driven by ‘tail events’ – a small number of events that drive majority of the impact.
Many large companies acknowledge this. One might intuitively think that the CEO of a company facing a major product setback ought to apologize to shareholders. But this is what Jeff Bezos said shortly after the disastrous launch of Fire phone, “if you think that’s a big failure, we are working on much bigger failures right now. Some of them are going to make the Fire phone look like a tiny little blip.” Amazon Prime and Web Services make so much money for Amazon, that it is ok to lose a few hundred million on a failed phone. But come to think of it, Web Services, when started, had a similar probability of failing.
If we take a giant step back, this becomes even more evident. Evolution has forged the entirely of the sentient life on this planet using one tool, and one tool alone – MISTAKE. The Cambrian explosion happened around 541mn years ago. Before that, organisms were relatively simple. The rate of diversification increased dramatically after the explosion. Post the explosion (The Palaeozoic era) first creatures with central nervous system emerged, but the Permian Triassic extinction wiped off 96% of marine species (oops, mistake. The extinction took just 50mn years. Let’s start again, shall we?).
During the Mesozoic era that followed, non-primate mammals evolved (like dinosaurs). But if they survived, how would humans get to the top of the food chain (which isn’t a big problem for nature, except that, who would invent ESG investing then!). Anyway, the KT extinction killed all the dinosaurs, and it took just 150mn years to settle down before the current Cenozoic era began.
A series of trials and errors just to bring us to a system where Amazon can be happy to have lost millions on a phone that didn’t work, and Netflix cancels several big budget films because their ‘hit ratio was way too high and they were not taking enough risks.’
Where does this bring us? In the journey of investing, all of us will likely make many mistakes. But consider this data point. The rolling median CAGR that one would have generated over a 3, 5 and 7-year period (between 1990 and today) is 9%, 10% and 11%, respectively. You could have chosen any random day to get invested and the probability that you would generate a positive return over 7-year period would have been close to 95% (assuming you had the worst luck, the loss would have been 6% CAGR, and assuming you had amazing luck, the highest returns would have been 28% CAGR).
With that in the backdrop, the bigger question is, what, in your opinion, is a bigger mistake–fearing that we might err in our decisions (which sector, which stock, whether now or wait for correction) every now and again or not getting meaningful exposure to equity even when markets look like they are trading at highs?
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