The Most Dangerous Word In Investing
When it comes to investing there is a single four letter word that in my nearly two decades of active investing experience has proved to be the most dangerous. It is a word that has a positive connotation in nearly every other area of life. It is a word that was used effectively in the campaign of a U.S. president that won the Noble peace prize. It is a word that has helped countless people survive tragic situations or insurmountable odds.
That word is hope. When it comes to investing, you have to invest based on facts, the ability to discern value where others don’t see any or to see around the curve at what is approaching. In investing, you do most of your homework up front and then let things plays out either as you expected or sometimes in a completely different way. Hope has no place in investing as hope can lead you to put good money behind bad, waste too much time and energy on a situation that is best forgotten or give you narrow tunnel vision where every new piece of information that does not meet your hopeful bias is discarded.
The following tweets illustrate how getting comfortable taking a small loss early can help.
A process like exiting a position if it drops X% below your purchase price can help limit the negative impact of hope. The challenge lies in figuring out what that X% should be. Should you exit after the position drops by 10%? How about 20% to limit the impact of general market volatility? This is a difficult question to answer because it is hard to time the exact entry into a position or the exit from an investment.
The flip side to this is that as a long-term investor you want to ignore the noise of daily price fluctuations and focus on how the company is doing by both looking at quarterly earnings as well as the public perception of the company if it is consumer focused. You need enough confidence to hold on to the position through short-term weakness. One way to gain this confidence is by doing enough independent work on the investment before you buy so you understand the strengths and weaknesses of what you are getting into. Playing devil’s advocate to your enthusiasm for an investment should help you think about the risks of the investment and if the risk/reward profile makes sense. Just don’t do too much of it, otherwise you might end up with decision paralysis.
The antidote to hope when it comes to investing is confidence. Confidence in your process, in your experience, the work you did in understanding the company’s business model, the work you did in valuing the company, the work you did in understanding sector dynamics and finally the macro economic picture.