All investors make mistakes. After all, it is impossible to have a 100% track record when apportioning capital. Ultimately, some unforeseen challenge or threat can appear that causes a company’s performance to deteriorate or underperform versus an investor’s expectations. As such, all investors will, at times, make mistakes when deciding which companies to buy and hold.
A quick fix
While mistakes cannot be completely avoided, investors can decide how they respond when errors occur. Indeed, it could be argued that having a plan to use in response to mistakes is just as important as a strategy to avoid them.
Arguably, the most important part of any such plan is to react quickly. It is all too easy to ignore mistakes in the hope they turn themselves around. For instance, an investor may hope that a holding is able to rebound from an unexpected annual loss or profit warning to deliver improving levels of profit.
In reality, however, delaying a decision can compound the impact of an error and lead to an even greater capital loss over the long run. This viewpoint has previously been discussed by Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) Vice Chairman Charlie Munger (Trades, Portfolio).
“One thing we’ve learned is, if it’s clear that something is a mistake, is to fix it quickly," he said. "It doesn’t get better while you wait.”
Overcoming emotions
Of course, selling a stock that has proven to be a mistake is easier in theory than in practice. Emotions can often cloud an investor’s judgment. For example, they may be averse to selling at a loss. Or they may feel they have put large amounts of time and effort into unearthing a stock and are unwilling to see that go to waste.
In addition, losses are unrealized until a stock is sold. Therefore, delaying the sale of a stock that proved to be an error maintains at least some hope of a recovery.
To overcome emotions, it may be logical to contemplate the opportunity cost of a mistake instead of focusing on the error itself. All too often, investors focus on the losses they have made in the recent past from a mistake, rather than the potential for future poor returns that are caused by failing to rectify a mistake.
By promptly realizing there may be an opportunity cost from continuing to hold a stock that turned out to be an error of judgment, investors may find it easier to sell up and move the capital to a more productive use.
Identifying mistakes
Clearly, there is a big difference between buying stocks that turned out to be poor businesses and purchasing shares that have underperformed expectations due to weak investor sentiment. For the latter, it can be worth sticking with sound businesses even if other investors are unenthused by their prospects. Indeed, their investment case could be made stronger by investor apathy via a lower valuation.
As such, it is important to correctly identify when a mistake has been made and when a solid business simply needs more time to deliver on its potential. However, where mistakes are made in apportioning capital to businesses that deliver poor financial returns, it may be prudent to act swiftly and decisively to minimize the impact on long-term returns.
