Morgan Housel at Motley Fool has a wonderful article on how investors can learn from failure. He sets the tone with a few different quotes and anecdotes that point out that a lot of being a success is just avoiding really dumb mistakes.
At a conference years ago, a young teen asked Charlie Munger how to succeed in life. “Don’t do cocaine, don’t race trains to the track, and avoid all AIDS situations,” Munger said. Which is to say: Success is less about making great decisions and more about avoiding really bad ones.
People focus on role models; it is more effective to find antimodels—people you don’t want to resemble when you grow up. Nassim Taleb
I’ve added the emphasis, but Mr. Housel makes a good point. Learning from failure is equally important as learning from success. In fact, he argues it may be more important.
If it were up to me, I would replace every book called How to Invest Like Warren Buffett with a one called How to Not Invest Like Lehman Brothers, Long-Term Capital Management, and Jesse Livermore. There are so many lessons to learn from these failed investors about situations most of us will face, like how quickly debt can ruin you. I’m a fan of learning from Buffett, but the truth is most of us can’t devote as much time to investing as he can. The biggest risk you face as an investor isn’t that you’ll fail to be Warren Buffett; it’s that you’ll end up as Lehman Brothers.
But there’s no rule that says you have to learn by failing yourself. It is far better to learn vicariously from other people’s mistakes than suffer through them on your own.
That’s his thesis in a nutshell. He offers three tidbits from his study of investing failures. I’ve quoted him in full here because I think his context is important (and the writing is really good).
1. The overwhelming majority of financial problems are caused by debt, impatience, and insecurity. People want to fit in and impress other people, and they want it right now. So they borrow money to live a lifestyle they can’t afford. Then they hit the inevitable speed bump, and they find themselves over their heads and out of control. That simple story sums up most financial problems in the world. Stop trying to impress people who don’t care about you anyways, spend less than you earn, and invest the rest for the long run. You’ll beat 99% of people financially.
2. Complexity kills. You can make a lot of money in finance, so the industry attracted some really brilliant people. Those brilliant people naturally tried to make finance more like their native fields of physics, math, and engineering, so finance has grown exponentially more complex in the last two decades. For most, that’s been a disservice. I think the evidence is overwhelming that simple investments like index funds and common stocks will demolish complicated ones like derivatives and leveraged ETFs. There are two big stories in the news this morning: One is about how the University of California system is losing more than $100 million on a complicated interest rate swap trade. The other is about how Warren Buffett quintupled his money buying a farm in Nebraska. Simple investments usually win.
3. So does panic. In his book Deep Survival, Laurence Gonzalez chronicles how some people managed to survive plane crashes, getting stranded on boats, and being stuck in blizzards while their peers perished. The common denominator is simple: The survivors didn’t panic. It’s the same in investing. I’ve seen people make a lifetime of good financial decisions only to blow it all during a market panic like we saw in 2008. Any financial decision you make with an elevated heart rate is probably going to be one you’ll regret. Napoleon’s definition of a military genius was “the man who can do the average thing when all those around him are going crazy.” It’s the same in investing.
I think these are really good points. It’s true that uncontrolled leverage accompanies most real blowups. Having patience in the investing process is indeed necessary; we’ve written about that a lot here too. The panic, impatience, and insecurity he references are really all behavioral issues—and it just points out that having your head on straight is incredibly important to investment success. How successful you are in your profession or how much higher math you know is immaterial. As Adam Smith (George Goodman) wrote, “If you don’t know who you are, the stock market is an expensive place to find out.”
Mr. Housel’s point on complexity could be a book in itself. Successful investing just entails owning productive assets—the equity and debt of successful enterprises—acquired at a reasonable price. Whether you own the equity directly, like Warren Buffett and his farm, or in security form is immaterial. An enterprise can be a company—or even a country—but it’s got to be successful.
Complexity doesn’t help with this evaluation. In fact, complexity often obscures the whole point of the exercise.
This is actually one place where I think relative strength can be very helpful in the investment process. Relative strength is incredibly simple and relative strength is a pretty good signaling mechanism for what is successful. Importantly, it’s also adaptive: when something is no longer successful, relative strength can signal that too. Sears was once the king of retailing. Upstart princes like K-Mart in its day, and Wal-Mart and Costco later, put an end to its dominance. Once, homes were lit with candles and heated with fuel oil. Now, electricity is much more common—but tomorrow it may be something different. No asset is forever, not even Warren Buffett’s farmland. When the soil is depleted, that farm will become a lead anchor too. Systematic application of relative strength, whether it’s being used within an asset class or across asset classes, can be a very useful tool to assess long-term success of an enterprise.
Most investing problems boil down to behavioral issues. Impatience and panic are a couple of the most costly. Avoiding complexity is a different dimension that Mr. Housel brings up, and one that I think should be included in the discussion. There are plenty of millionaires that have been created through owning businesses, securities, or real estate. I can’t think of many interest rate swap millionaires (unless you count the people selling them). Staying calm and keeping things simple might be the way to go. And if the positive prescription doesn’t do it for you, the best way to be a good investor may be to avoid being a terrible investor!