It is common knowledge that in order to be a successful investor, you need to buy low and sell high. Unfortunately, the reality is few investors manage to accomplish this feat. It is more likely you will buy high and sell low.
Psychology helps explain why this is often the case. Investors do not like to be seen holding the bag when the rest of the market is selling. Additionally, the tendency to try to avoid losses means investors kick the can down the road with respect to selling. Only in hindsight, when you are sitting on losses of 75%, do you start wishing you had taken the loss at 50% and walked away.
The task of buying low and selling high is all the more difficult for value investors, who act with a contrarian nature in general and buy the junk other investors are selling. Of course, if you have done your research beforehand, the risk of falling into a value trap where the stock drops to zero is significantly reduced but not eliminated entirely. No matter how much work you do, you will never be able to spot every value trap before you invest--that is just part of investing.
Admitting these mistakes before they have a chance to inflict a terminal loss on your portfolio and learning from what went wrong are probably the most important parts of investing. Losses can be much more valuable than profits, something Ray Dalio (Trades, Portfolio), founder of the world’s largest hedge fund, knows all too well.
Dalio on mistakes
Bridgewater’s biggest mistake occurred during 1981-82 when Dalio was convinced the U.S. economy would fall into a depression.
“I was so certain that a depression was coming that I proclaimed it in newspapers columns, on TV, even in testimony to Congress. When Mexico defaulted on its debt in August 1982, I was sure I was right. Boy, was I wrong. What I’d considered improbable was exactly what happened: Fed chairman Paul Volcker’s move to lower interest rates and make money and credit available helped jumpstart a bull market in stocks and the U.S. economy’s greatest ever noninflationary growth period.”
This event taught Dalio a valuable lesson; you should always fear being wrong, no matter how confident you are. As a result, he decided to put in place a safeguard that would ensure he could never make the same mistake again. This safeguard was the addition of people to his team who were more than happy to argue against his view:
“...I began seeking out the smartest people I could find who disagreed with me so that I could understand their reasoning. Only after I fully grasped their points of view could I decide to reject or accept them. By doing this again and again over the years, not only have I increased my chances of being right, but I have also learned a huge amount.”
The addition of this extra level of security helps Dalio build confidence that he is making the right decisions.
“This approach comes to life at Bridgewater in our weekly research meetings, in which our experts on various areas openly disagree with one another and explore the pros and cons of alternative view. This is the fastest way to get a good education and enhance decision-making. When everyone agrees and their reasoning makes sense to me, I’m usually in good shape to make a decision. When people continue to disagree and I can’t make sense of their reasoning, I know I need to ask more probing questions or get more triangulation from other experts before deciding.”
Most investors do not have a team of hedge fund experts at their disposal, so if you are not Dalio, you will not be able to replicate this approach in its entirety.
The key takeaway here, however, is that it is always best to challenge your decisions and, rather than accept an investment thesis at face value, it is best to question why it is what it is and be prepared for all situations. Such analysis should help you avoid falling into the buy high, sell low trap.
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