Do you Want to be Proud, or do you Want to Make Money?
Abnormal Returns, my favorite investing blog, had a piece yesterday entitled: Being right is overrated. It was a good post, but I felt I needed to take the other side of the argument, because I have heard this argument too much recently. Here is what I wrote:
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I’m going to take the other side of this one. This is a bear/choppy market argument. During a sustained bull market, being right makes lots of money.
When I choose stocks, I do all that I can to have the odds tipped in my favor — industry analysis, earnings quality analysis, valuation analysis, balance sheet analysis, free cash flow use, and even a review of the anomalies like momentum, volatility, balance sheet growth, etc.
It’s not perfect, but I typically have 70% winners, and my winners are larger than my losers. Being right helps make money… does anyone doubt that? But hubris destroys.
Does that mean I give up my risk control disciplines? No. I get things wrong, and when I am wrong, I cut my losses. Every 20% move down requires a review — if the thesis is intact, I buy enough to rebalance. If not, I sell.
Also, my methods continually improve my portfolio, selling things with less potential to buy things with greater potential.
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I’ll give you this — I knew a fellow for whom every position was a holy crusade. The regret level was high. He always wanted to win, and win big. Risk control took a back seat. If his staff had not been correct with a high level of frequency, his asset management firm would have died. As it was, they were constantly dealing with shorts running against them, with the pain of increase, cover some, go flat. Usually it went first increase, increase a little more, then cover some, some more, some more, until the momentum broke, and they would scale out with modest losses. And, the opposite with longs going down, but they wouldn’t rebalance like I do; they would double the position.
Toward money management of this sort, I would say, “Do you want to make money, or do you want to be proud?” Pride goeth before a fall (Pr 16:18). It’s fine to want to be right, and to aim for it, but it is wrong to not be modest, and realize that we will be wrong, and methods must be employed to limit losses when we are wrong.
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Humility is an asset in all of life — it is even more so when it comes to asset management. Reckless, macho asset management tends to lose, while those that focus on “what could go wrong?” tend to win. Ben Graham’s main idea was not cheapness, it was margin of safety — we need to focus on safety more, and cheapness less.
June 5th, 20092:26 am at
“It’s not perfect, but I typically have 70% winners, and my winners are larger than my losers”
I don’t mean to nitpick, but if you were truly humble – an essential asset for money management as you say – perhaps the above should read:
“It’s not perfect, but I typically have had 70% winners, and my winners have been larger than my losers”
After all, the past is no guarantee of the future.
June 5th, 20091:15 pm at
Stevie b,
You’re nitpicking. I have read Mr. Merkel’s posts for years. He is humble and wise.
June 5th, 20091:57 pm at
I managed money on Wall St. relatively successfully for nearly 30 years. I recognised that markets always made me humble, usually right after I thought I was the smartest guy on the block. Having read his blog for well over a year, I do not doubt that David is wise, but I do feel justified in gently probing the depth of his humility.
June 5th, 20092:46 pm at
C, I’ll take the rebuke from SB. There were better ways to say what I said. A 9-year track record on my strategy is good, and it has been a more consistent strategy than most, but it too can fail. Perhaps I should re-read my disclaimer at the bottom of the page — the markets always find a new way to make a fool out of you — and that means me too.
June 5th, 20093:23 pm at
Indeed, I wanted to make money . . .
. . . that is, until I took your recommendation to buy DFR.
(a very poor) Sam
June 5th, 20093:27 pm at
David – nice & well said (& I expected nothing less of you) – cheers!
June 5th, 20097:30 pm at
Indeed, poor Sam — DFR was one of my biggest blunders, and my biggest loss ever. That you lost money on it too makes it all the worse for me. My apologies again.
June 5th, 20097:35 pm at
If you can strictly define your risks on every trade ,you will succeed
June 6th, 20099:00 am at
It’s useful to understand that there are different ways of being “right” or “wrong” that may have different investment implications. Here are a few relevant ones:
1) One may have a directional thesis on a stock that is right over time frame A but wrong over the different time frame duration B; someone could maximize profits by always being right about the short term time frame, but someone who has a method for predicting longer term time frames but no method for predicting short term time frames might have much higher percentages at those time frames than the shorter ones (I guess this is something like David’s point);
2) one might be “right” that factor A will affect a stock but be wrong about the overall directional prediction for the stock because of some other factor B (which could be anything from poor management to a stock market crash);
3) one might be “right” that factor A is important to a stock but “wrong” about its effect on future price movement because of an incorrect assessment about whether the import of factor A is already priced in (e.g. stock’s which fall after apparent earnings beats).
I agree that with both David and Abnormal Returns that psychological biases are a big problem for investors, but just wanted to point out that being right in the right way is also very important.