Why You Stink as an Investor -- and How to Change That

The making of the world's most successful investors has hinged on their ability to master one simple concept: feedback loops.

Understand them, and the quality of your decision-making skyrockets. Ignore them, and you'll be paying the price for the rest of your life.

What do I mean by feedback loops, and how can they be misunderstood? Let's look at the most basic way to think about this concept.

Feedback loops often occur in our life so quickly and seamlessly that we don't even know they're happening. Let's use taking a shower as an example:

  1. Turn the shower knob on.
  2. Feel the water to test the temperature.
  3. Decide whether the temperature needs to be adjusted at all.

Usually it's a good thing that we aren't consciously aware of these loops, or our brains would explode from thinking about their constant ebb and flow.

But at other times, being unaware of how feedback loops work can have some serious consequences. That's because, looking at the picture above, there's one crucial step missing. Here's what the loop really looks like.

If your shower has ever been like the one I had my first year out of college, you know what I mean -- it would usually take five minutes before the knob setting and the actual water temperature matched up. If I hadn't been aware of this delay, I would've suffered through ice-cold water only to later get my skin burned because I consistently turned the knob to a hotter temperature.

The delay makes all the difference
Spotting and being aware of these delays isn't necessarily hardwired. We love getting instant feedback, and in many areas of life, that's how we improve. The budding quarterback knows almost immediately if he needs to change his form, because he instantly sees the result of his pass. The same is true for almost all athletes.

But it's also not hard to spot real-life examples of important delays in a feedback cycle.

For instance, when a drug company wants to get a new treatment approved, it has to go through multiple stages of laborious FDA trials before being allowed to sell the drug publicly. That's because there could be a significant delay between when a patient uses the drug and when potential side effects could surface.

How this applies to investing
If you're a Foolish investor -- and I hope you are -- you view owning stock in a company to be the equivalent of owning a piece of a living, breathing, dynamic organization. When you make an investment, it's based on two things: the potential you see in the business and the price you pay. Daily swings in the market shouldn't affect your decision; you're focused on the long-term arc of a business.

But all too often, a stock dives for any number of reasons -- an analyst downgrade, a short attack, or disappointing earnings, to name a few -- and investors bail. Doing so completely disrespects the delay in an investment feedback loop. If you're doing it right, that delay should be -- at a bare minimum -- three years.

If you make decisions based on short-term movements instead of waiting for the loop to complete itself, you'll end up moving in and out of investments at inopportune times, racking up heavy tax and transaction costs along the way. Over time, that can be very costly.

A real-life example
Back in August of last year, I invested some of my own retirement money in Organovo (NYSEMKT: ONVO) , one of the only publicly traded bioprinters on the market. In its whole life as a company, Organovo has made next to no money while racking up huge costs. By almost any metric, it's a stupid investment.

So why did I buy shares? Because if the company is able to execute on its plans, it could completely revolutionize how pharmaceutical companies take drugs to market. Organovo is set to bring its first real product public by the end of the year: 3-D liver tissues that will help detect toxicities earlier than is currently possible -- with the potential to save millions for its customers.

Over the time that I've owned the company's shares, Organovo's stock has taken drastic swings. Currently, it sits about 88% higher than when I bought it -- but I certainly haven't sold. And I'm fully aware that should some bad news surface, it could fall all the way back down -- but that won't cause me to sell, either.

When I invested in the company, it was because it has the potential to print all sorts of human tissues that could help the medical community. It will likely take years to see if that promise can be fulfilled. The feedback loop won't close on my investment for years -- and that's why I won't be touching my original investment until that time comes.

While Organovo might be an extreme example, it's instructive in showing how learning about feedback loops, and respecting their delays when it comes to investing, can be the difference between financial freedom and frequent financial failures.

 

 

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