You invest your money in the stock market to achieve superior returns and you do that by finding quality stocks and constructing an efficient portfolio. It is unrealistic to expect all stocks in your portfolio to perform equally well. The best you can do is to ride the winner stocks (that gives superior return) and, at the same time, cut the loser stocks (that gives inferior return or make losses). This approach can help you, eventually, to achieve a superior return in the long run.
But this is easier said than done. What we usually observe in markets is that – investors sell their winners too early – meanwhile, they keep holding on to their losers. These two are the most common mistakes investors make.
This post discusses one of the mistakes – Holding on to the Losers – and two major reasons why investors hold onto their losers: 1) confirmation bias and 2) wishful thinking. I also suggest an approach – the path of mistakes – which may seem preposterous, at first, but might help liberate yourself from committing these mistakes again in the future.
Confirmation Bias
Confirmation bias is the tendency to look for or accept only new information that supports your beliefs or conclusions and reject any new information that contradicts your beliefs or conclusions.
Suppose that you have invested in a stock that you consider to be of high quality; having bright prospects; and trading at a fair valuation. You formed this belief or arrived at the conclusion because you found the stock to have: 1) high profitability; 2) robust balance sheet; 3) above-average earnings growth; and 4) superior cash flows.
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Assume that sometime after your investment the stock started reporting weak earnings that resulted in a marked decline in earnings growth. Your mind’s immediate, intuitive response would be to trivialize the new information as it contradicts your already ingrained belief about the stock. And any decline in stock price due to weak earnings will seem short-term and transient. This intransigence can continue for some time during which new information that contradicts your beliefs – and the resultant stock price decline – fails to gain your attention.
But this decoupling between reality and your belief can’t continue indefinitely. A mental discomfort, that has been gradually gaining strength subconsciously, regarding the particular investment position, enters your conscious mind. It becomes so intense that you either must let go or at least show some form of scepticism towards your belief. You risk insanity by further holding onto your belief.
You don’t have to let things reach these levels. The pain and losses could be avoided through a change in mindset.
The best way to deal with such situations is to resist the tendency to form any kind of belief or conclusion based on the limited information you have. For every piece of information that you know about the stock, there would be five other pieces that you are unaware of. So any belief or conclusion reached with what you know shall result in an incomplete, wrong, or distorted view of the stock’s reality.
A more appropriate method would be to invest in a stock if you find it to have a high prospective return after a basic analysis and valuation. A more detailed analysis can be done later, after the investment. During this post-investment detailed analysis, you can look for information that contradicts or challenges your argument, not that is in support of your argument.
How could things go wrong?; how probable are they?; and if so, how much do I lose? This kind of cross-analysis shall help you avoid holding onto losers.
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Wishful Thinking
Wishful thinking usually happens – but is not limited – to people who invest their money based on other people’s (expert) opinions, advice, or suggestions.
People get excited about a stock idea after knowing about it from some external source – friends, news media, social media, etc. They get emotionally attached to the idea and invest in the stock desiring large returns.
However, after some time, the stock starts moving in a direction opposite to their intentions or desires – as typically happens with popular stocks – resulting in capital losses and suffering. They deal with the capital losses and associated suffering by indulging in wishful thinking.
They visualize unachievable or impractical scenarios where the stock recoups the losses and goes on to achieve its desired return – and then waits for the wish to materialize in the real world. Unfortunately, with no fact or reason backing their wishful thinking, such wishes never materialize. What typically happens is that the losses keep compounding, while the investor stays delusional under the influence of their wishful thinking.
The first step toward progress in such situations occurs when the investor acknowledges and accepts that a mistake has been made, and then shows a willingness to learn from the mistake through reflection.
The Path of Mistakes
People make mistakes – you make mistakes – we all make mistakes. Our biases and delusions are one reason behind our mistakes. But, what are our biases and delusions? It would be helpful if we could know what all our biases and delusions are because eliminating or neutralizing them can help in avoid mistakes. But it is not easy to identify our biases and delusions because they reside in our heads labelled as ‘understanding’ and ‘knowledge’ – not as ‘biases’ or ‘delusions’.
We know ‘understanding’ and ‘knowledge’ are essential for quality decision-making, and we also know that our biases and delusions can result in poor decisions. The real problem is that we are not aware of our biases and delusions as they reside in our mind masqueraded as ‘knowledge’ or ‘understanding’. We are not cognizant of our biases and delusions and their insidious nature.
So how do we unmask and bring to light biases or delusions residing in our heads?
Even though it seems weird, our mistakes can help us unmask the biases and delusions that caused the mistake in the first place. Everyone tries to avoid mistakes. There is also a social stigma associated with making mistakes. But amusingly, mistakes are the best tool to unmask the biases, delusions, and ignorance that hinder our progress in life, investment, or relationships.
Most people have a negative perception of mistakes. They consider mistakes as bad and thus try to avoid them at all costs. Some even go to extremes to cover it up.
You need to first acknowledge and accept your mistakes to learn from them. Be comfortable with making mistakes, embrace your mistakes, and then learn from them. If you don’t learn from your mistakes, you are bound to repeat them.
Albert Einstein has said this about mistakes – “Those who haven’t made any mistakes are those who haven’t done anything”. Jeff Bezos, Amazon.com founder had said, “I am successful because I have made a lot of mistakes, billions worth of mistakes.” He encourages his employees to make mistakes and to make them fast.
Most people make a lot of preparation – in life and work – to excel at them. They prepare because they don’t want to fail, they don’t want to make mistakes. But some things in life can be learned only through mistakes and failures. Those are the real knowledge; we call it wisdom. Wisdom is the knowledge that liberates us from our shackles.
A fifty-six-year-old man once got admitted to a hospital. The doctor diagnosed him with a terminal illness and told him that he had only 6 months to live.
The man in shock and disappointment said: “What! 6 months. But I haven’t yet started living?”
Hearing this, the doctor asked, curiously: “Then what have you been doing all these years?”
The Man replied: “Preparing. Getting ready for life.”
“For 56 years??” the doctor asked, unbelievably.
The man after a few moments of silence, said thoughtfully: “Yes… so much wasted time”.
You might be able to prepare for an exam, interview, meeting, or presentation, but you can’t prepare for life. You never know what life is going to throw at you, then how come you prepare for it?
I suggest ‘Don’t Prepare’, ‘Act Now’, and ‘Make Mistakes’ as three steps that can lead you to wisdom and liberation – and a more contented life – by exposing the biases and delusions that have been, so far, preventing you from attaining that contentment.
AMN CAPITAL 
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