The Virtuous Investor: Rule 12

Turn your weaknesses into strengths – reinforce your virtues when tempted

This post is part of a series on The Virtuous Investor. For an overview of the series and links to the other parts, click here.

“And thus shall it be brought about that every temptation may be a certain renewing of thy holy purpose, and an increase of piety and virtuous living.”

Erasmus of Rotterdam

So, you bought some Turkish small cap stocks and lost big time. You gave in to your desire to trade and now you fear, you have messed up your portfolio for this year because you ignored Rule 8 of The Virtuous Investor? Or worse, you gave in to the optimistic story a charismatic CEO of a growth company told you (Uber, WeWork, anyone? Anyone?). Now you have lost basically all your money in that investment because you ignored Rule 10 of the Virtuous Investor You followed the herd instead of analysing the investment with regards to your personal needs and the investment has turned sour. Have you not been listening to Rule 6 of the Virtuous Investor?

DON’T PANIC

We all make mistakes. All the time. Even the best of us. Even I make mistakes.

Making mistakes is human. It is how we react to making mistakes that differentiates between the good and the mere average.

In the UK, the Daily Telegraph regularly interviews famous and not so famous fund managers in a standardised format. One of the standard questions they ask them is to disclose their worst investments. Here are some examples:

Kevin Murphy:

There have been plenty of mistakes, but the biggest was RSA Insurance. It was a position we inherited when we took over the fund in 2010 and despite having doubts the management team won us over. In 2013 there was a rights issue and we lost money. It taught us to focus on the numbers as opposed to the narrative sold by management.

Hugh Yarrow:

We invested in a French media firm, Vivendi, four years ago but had to sell at a slight loss as it had some problems with its telecoms business. We have now tweaked our investment process and would not invest in a ‘capital-intensive’ business again.

David Coombs:

I've always been reluctant to pay up for 'growth' companies. In 1999, valuations and hype were shocking, but eventually you think you must be wrong and everyone else is right. It was a massive company - too big to fail. But of course, it wasn't, because it went bust. That was my mistake - I didn't have the courage of my convictions and assumed that the rest of the world was right. You need to ignore the noise and have courage, without becoming too arrogant.

And of course, there is Warren Buffett:

Obviously, I should have bought [Amazon] long ago, because I admired it long ago… But I didn’t understand the power of the model as I went along. And the price always seemed to more than reflect the power of the model at that time. So, it’s one I missed big time

But all of these investors have learned from their mistakes. Warren Buffett is probably the most open about his investment mistakes and analyses them carefully in every one of his letters to shareholders. Most recently, his failed investment in Kraft Heinz led him to admit that he overpaid for the stock.

And just like the best investors in the world make mistakes, so will every investor. The trick is to deal with mistakes properly, so you can turn them into an opportunity to become a better investor in the future:

  1. First, you must recognize a mistake as a mistake. Too often, investors just close their eyes in the face of failed investments. They become increasingly stubborn about their original investment thesis. For example, they might become convinced that an investment is overvalued and thus needs to be shunned in a portfolio. But as the investment continues to rally, it becomes even more expensive. At some point you need to acknowledge, like Buffett did with Amazon, that you underestimated the growth potential in that investment.

  2. Second, you need to admit you made a mistake. Admitting a mistake publicly puts you under pressure not to make the same mistake again. Admitting a mistake makes you feel at least slightly ashamed, which is why it is so difficult to do. But this feeling of shame can be the fuel that drives you to becoming a better investor. Warren Buffett’s approach to admitting mistakes is ideal. He literally tells everyone who cares to listen what mistakes he made. If you don’t want to be quite so open about your mistakes, you may want to create a little poster about your investment mistake that you can hang on your office wall to remind you of it.

  3. Third, you need to analyse the mistake. What did you do that caused that mistake? Did you stray from your usual investment process? If so, how and how did that influence your decision? If you did not stray from your investment process you might have discovered a flaw in the existing process. How can you improve your process going forward? As Hugh Yarrow learned from his investment in Vivendi, his investment process did not warn him of the pitfalls of capital-intensive businesses, a mistake that Warren Buffett made as well when he bought US Air in the early 2000s.

  4. And fourth, you need to learn from your mistake. Once you know what went wrong, you need to adjust your investment decision making process to include what you learned from your analysis.

Ideally, you can start an investment checklist that lists in bullet points all the things you need to look out for before you make an investment. I learned about investment checklists and their power from another great investor, Guy Spier, who writes about it in his book, The Education of a Value Investor:

The goal in creating a checklist is to avoid obvious and predictable errors. Before I make the final decision to buy any stock, I turn to my checklist in a last-ditch effort to prevent y unreliable brain from overlooking any potential warning signs that I might have missed. (page 151).

I encourage you to use your mistakes to build your own investment checklist. And trust me, you cannot copy past an investment checklist from anyone, because it has to reflect your personal investment style and your personal weaknesses and strengths. My checklist will not be useful for you and your checklist will not be useful for me. But over time, your investment mistakes will lead to an investment checklist that will become your major investment strength. As Guy Spier puts it:

It’s an incredible piece of intellectual property. (p. 155)