This friend of mine is hanging out in a Vegas casino, playing a game of blackjack. He's sitting on 18, and the guy has the chutzpah to ask the dealer for a hit. Everyone at the table gasps. I call him an idiot. Sure enough, the dealer flips over a 3, and suddenly the guy and everyone else at the table thinks he's some sort of gambling genius.
OK, he won the hand, but that's not the point. It was about as stupid a move as it gets. He should have lost. The rest of the table was right to laugh at him. Instead, he walked out with his head held high, acting as if his success was completely attributable to his audacious approach to risk and his sense that he was controlling the deck.
Profiting from idiocy
This kind of stuff happens in the stock market every day. Stocks go up, they go down, and they go sideways. The short-term movements have absolutely nothing to do with your skill -- they're just random chitter-chatter. Sometimes the cards fall in your favor and you do well, even in cases where you should have lost. Sometimes you lose money, even in cases where the odds say you should have done well.
Having a streak of winning investments doesn't mean anything if the logic behind them was faulty. And as crazy as it sounds, having a portfolio of losing investments doesn't mean you're a bad investor, as long as your reasoning was sound and logical to begin with. If you want to stay in the game for a long period of time, your process is more important than your short-term outcomes.
The only certainty is that there is no certainty
The fact is, there's no way to understand every detail about your investments. The best you can hope for is to be mostly right about your future predictions. That being said, there's always the possibility that surprises will come up -- for better or worse.
Of course, the most successful investments are those where the probability of success far outweighs the probability of failure. That might be obvious to you, but you'd be surprised how many investors fail to grasp the concept.
High uncertainty, low risk
Value investing guru Mohnish Pabrai turned heads when he purchased 15% of Venezuelan oil company Harvest Natural Resources (NYSE: HNR ) earlier this year. Harvest's business structure has been thrown upside down by Hugo Chavez's socialist government, presenting a huge risk indeed to investors. Not surprisingly, many fled the stock in droves, not knowing what the final outcome of the situation would be.
But Pabrai, as an astute value investor, saw the forest despite the trees. A careful examination of the conversion process showed that it had a very high probability of going through successfully, leaving Harvest better off than it was in the past. Was there risk that Chavez could step in and wreak havoc? Of course, and there still is. But the odds of that happening paled in comparison to the odds of a successful and profitable transition. Since the odds of success were better than the odds of failure, even if he ends up losing money on the investment, it was still a good idea. If you always invest with this mindset, you may hit some bumps in the road, but over time you'll do just fine.
Hitting on 18, Wall Street style
What about the opposite situation? Just like my blackjack-playing friend lucked out on a stupid move, investors who partake in investments where the odds of failure outdo the odds of success are setting themselves up for trouble -- even if they end up making money here and there.
Think about the astronomical valuations put on Internet highfliers like Yahoo! (Nasdaq: YHOO ) and Cisco (Nasdaq: CSCO ) back in the dot-com mania days. You could have invested in these companies before the curtain came down in 2000, and you would have made money. But that doesn't mean you would have been a smart investor. Sooner or later, mistakes will catch up with you and leave you searching for answers in a pile of worthless stock certificates. It's like Russian roulette: Even if you win, you're still dumb to have played at all.
It's a hard thing to do, but at the end of the day, don't focus on how much money you made. Focus instead on your reasoning for investing in the first place. If your reasoning was sound, but you don't end up doing as well as you thought, don't get down on yourself. In the long run, you'll be sitting pretty.
Until then, check out this related Foolishness: