Limits to learning

Learning From Our Investing Mistakes

We all think we learn from our mistakes, but do we?. When we make a losing investment, do we recognize our mistake and learn from it, or do we attribute it to some outside factor, like bad luck or the market? Well, to be successful as an investor and trader, we must recognize our mistakes and then learn from them. Unfortunately, learning from these mistakes is much harder than it seems.

Some of you probably have heard of this experiment. It is an example of a failure to learn during a simple investment game devised by Antoine Bechara. Each player was given $20. They had to make a decision on each round of the game: invest $1 or not invest. If the decision was not to invest, the task advanced to the next round. If the decision was to invest, players would hand over one dollar to the experimenter. The experimenter would then toss a coin in view of the players. If the outcome was heads, the player lost the dollar. If the outcome landed tails up then $2.50 was added to the player's account. The task would then move to the next round. Overall, 20 rounds were played.

The chart below shows there was no evidence of learning as the game went on. If players learned over time, they would have realized that it was optimal to invest in all rounds. However, as the game went on, fewer and fewer players made decisions to invest. They were actually becoming worse with each round.

So how do we learn from our mistakes? What techniques can we use to overcome our "bad" behavior and become better investors? The major reason we don't learn from our mistakes (or the mistakes of others) is that we simply don't recognize them as such. We have a gamut of mental devices all set up to protect us from the terrible truth that we regularly make mistakes. We also become afraid to invest, when we have a losing experience. Let's look at several of the behaviors we need to overcome.

I Knew That

Isn't hindsight a wonderful thing? As a Monday morning quarterback we can always say we would have made the right decision. Looking again at the experiment mentioned above, it is easy to say, "I knew that, so I would have invested on each flip of the dice". So why didn't everyone do just that? In my opinion they let their emotions rule over logical decision making. Maybe they their last several trades were losers, so they become afraid to experience another losing trade.

The advantage of hindsight is we can employ good logic as we evaluate the decision we should have made. We also avoid the emotion that gets in our way. This emotion is the worst enemy of any good investor. To help overcome this emotion, I recommend that every investor write down the reason they are making the decision to invest. Documenting the logic used to make an investment decision goes a long way to remove the emotion that leads to poor decisions. To me the idea is to get into the position where you can say "I know that" rather than I knew that. By removing the emotion from your decision you are using the logic you typically use in hindsight to your advantage.

Self Congratulations

Whenever, we make a winning investment, we congratulate ourselves for making such a good decision based on our investing prowess. However, if the investment goes bad, then we often blame it on bad luck. According to psychologists, this is a natural mechanism that we, as humans possess. As investors it is a bad trait to have.

To combat this bad human trait, I have found that I must document each of my trades, especially the reason I am making the decision. I can then assess my decisions based on the outcome. Was I right for the right reason? If so, then I can claim some skill, it could still be luck, but at least I can claim skill. Was I right for some spurious reason? In which case I will keep the result because it makes me a profit, but I shouldn't fool myself into thinking that I really knew what I was doing. I need to analyze what I missed.

Was I wrong for the wrong reason? I made a mistake and I need to learn from it, or was I wrong for the right reason? After all, bad luck does occur. Only by analyzing my investment decisions and the reasons for those decisions, can I hope to understand when I was lucky and when I have used genuine investment skill. But first I must document my rationale for making the trade decision. For my Premium Members, I give the rationale for each trade as my way demonstrate this necessary discipline.

Luck Becomes Insight

The market we work so hard to understand is comprised of a series of cause and effect actions which are not always transparent. This cause and effect has created some interesting behaviors by some very successful people. For example, some baseball pitchers are known to not step on the white chalk line when they are playing. I am sure you have heard of many "superstitions" that people hold to be true to help them perform well.

In an experiment by Koichi Ono's in 1987, subjects were asked to earn points in response to a signal light. They could pull 3 levers, though they were not told to do anything in particular. They could see their score on a counter, but did not know that points were awarded completely independent of what they did. Nothing they did influenced the outcome in terms of points awarded. During the experiment they observed some odd behavior as the participants tried to make the most points possible. Most subjects developed superstitious behavior, mainly in patterns of lever-pulling, but in some cases they performed elaborate or even strenuous actions. Each of these superstitions began with a coincidence. In some cases the participants would pull levers in a particular sequence. In other cases even more odd behavior was observed including a person who jumped off a table and then later jumped up to touch the ceiling to "score" points. Keep in mind the points were awarded either on a fixed time schedule or on a variable time schedule, not based on the action of the participant.

The point of this is that as humans we tend to think that luck is insight. We fail to effectively analyze the situation and the real reason for our success or failure. In investing this behavior will lead to ruin. To help overcome our natural tendency, we must document our investing decisions and then assess the results. This assessment process helps us learn from our success and from our failures and is critical for each of us if we hope to become successful investors.

Conclusion

So what should you document before you make an investment trade? For my Premium Members each stock on the watch list includes three groups of items to document. First, I look at a series of fundamental information such as Earnings yield, Return on Capital, revenue growth, insider holdings, sector, and dividend yield. The fundamental information helps me identify if this is a good company with growing earnings, good management and has potential. After reviewing the appropriate financial information including SEC documents, I identify the risks inherent in the company. These risks might include competition, market share, insider transactions, and any litigation that the company is experiencing. Here one needs to try to identify every possible risk and assess them critically. Finally, I look at the chart of the stock, seeking to identify support and resistance zones. This gives me potential entry points, exit targets, and the trailing stop loss. I complete section with a written trading strategy describing how I expect to make my trades. All these investment factors should be documented before making a trade. Below is an example for N S Group from the Stock Watch list.

N S Group Inc. NSS 6/28/06

NS Group, Inc. manufactures and supplies tubular products to the energy market in North America. The company’s energy related products include seamless and welded tubular products, such as drill pipe, casing, and production tubing used in oil and natural gas drilling and production operations. It also manufactures seamless and welded line pipe primarily used as gathering lines for the transmission and distribution of oil and natural gas by utility and transmission companies. NS Group’s line pipe is also used in various construction applications. It also offers other products comprising standard pipe, piling, and steel billets. The company produces its products in various diameters, gauges, grades, and end finishes. It sells its products to distributors and end users.

Fundamentals

Pre Tax Earnings Yield
17.3%
Sector Energy - steel & composite pipe

Pre Tax Return on Capital
95.9%
Trailing P/E
8.4

Quarterly Revenue Revenue Growth (YOY)
37%
Price/Sales 1.8

Dividend Yield
0%
Price/Cash Flow 7.9

Market Capitalization
$1.19B
Price/Book 3.4

Earnings date
7/24/06
Conference Call 7/24/06

Insider holdings
.4%
Cockroaches None found

Risk Assessment: Closely tied to drilling for oil and gas in the US. Should the price of oil and/or natural gas fall it will negatively impact the earnings and therefore the price of the company.

Technical’s stock chart from StockCharts.com

Ave Volume (50 day)
520k
Pattern
Ascending triangle

Trade Management

Buy Range 45 Holding period
1 year

Stop Loss 7.3% or 3.66 points Risk-Reward
2.9 & 5.4

1^st Sell Target 55.8 2^nd Sell Target
65

Trade Strategy: Look to buy at or near support. The 50 day moving average (DMA) is acting as support as well. Sell 1/2 at 55-56, while moving up stop, possible tightening to 2.7-3 below current price. If resistance at 55.85 is broken with strong volume (130% or more of 50 DMA consider holding and buying more. Remember keep up with your stops to preserve capital.

To change our behavior we need to document our actions before we make the decision. We also need to be honest with ourselves when assessing our results. As we have seen it is quite easy for each of us to put on rose colored glasses and think we are better as investors than we really are. We need to critically assess our investing abilities without distorting the feedback we receive from our decisions. Those of us who are able to learn this valuable skill will greatly benefit. Those of us who are unable to apply this learning will be destined to mediocrity at best and likely lose much of their capital before they quite investing.