The Best Way to Learn As an Investor

I made my worst investment seven years ago.

The housing market was crumbling, and a smart value investor I idolized began purchasing shares in a small, battered specialty lender. I didn't know anything about the company, but I followed him anyway, buying shares myself. It became my largest holding -- which was unfortunate when the company went bankrupt less than a year later.

Only later did I learn the full story. As part of his investment, the guru I followed also controlled a large portion of the company's debt and and preferred stock, purchased at special terms that effectively gave him control over its assets when it went out of business. The company's stock also made up one-fifth the weighting in his portfolio as it did in mine. I lost everything. He made a decent investment.

The silver lining is that I learned my lesson. I will never make this mistake again. Experiencing it made me a better investor.

But so many other investors made this mistake before I did. There is a graveyard of investors like me who got burned by blindly following legendary investors without knowing why those legends invested in the first place. Wouldn't it have been great if I learned from their errors, rather than experiencing the loss myself? I made this mistake in my early 20s. Every dollar I lost is a dollar that won't compound for the rest of my life. By the time I retire, this blunder may easily cost me $1 million.

Capitalism is all about making, and learning from, mistakes. Jeff Stibel, CEO of Dun & Bradstreet Credibility Corp., made this point well in Megan McArdle's new book, The Up Side of Down. "The brain is a failure machine," he said. "When you're born, you have about all the neurons you'll ever have. When you're four, you have pretty much all the connections between those neurons you'll ever have. Then the brain starts pruning. The brain starts shrinking. You're actually learning by failure."

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.

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.

I think this is especially true in investing, where luck plays a larger role than most of us think. You are more likely to learn valuable lessons from failed investors than successful ones, because successful (especially very successful) investors likely experienced some degree of luck, while failed investors likely made bad decisions in situations that you yourself will someday face.

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 LivermoreThere 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. So why wouldn't you try to learn more from the latter? 

Focusing on failed investors over the years has taught me a few valuable lessons.

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.

Mark Twain once said that, "If you hold a cat by the tail, you learn things you cannot learn any other way." I disagree. Watch someone hold a cat by the tail and learn from their mistake vicariously. It's so much easier.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics. 

 


Read/Post Comments (18) | Recommend This Article (86)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 25, 2014, at 12:36 PM, Mathman6577 wrote:

    Good article. Finance (especially investing) is a lot like engineering actually. I work in the aerospace field where much of the engineering is focused on safety and what can go wrong instead of how it can go right. A failure provides more valuable information than a success. Hence a lot fewer planes crashes over the last 30 years.

  • Report this Comment On February 25, 2014, at 5:00 PM, daveandrae wrote:

    Mistakes are a part of the investment process.

    Over time, you will find that your error rate goes down not by admission, but by omission.

  • Report this Comment On February 25, 2014, at 8:10 PM, TheCommonTulip wrote:

    Morgan,

    You aren't opposed to ETF's that act like an index (say, S&P 500) correct?

    Adem

  • Report this Comment On February 26, 2014, at 1:38 AM, zinser wrote:

    Enjoy your writing Morgan,

    One point, you pulled a quote from Megan McArdle's book upside of down (confusingly enough the same name of a book published in 2006):

    ""The brain is a failure machine," he said. "When you're born, you have about all the neurons you'll ever have. When you're four, you have pretty much all the connections between those neurons you'll ever have. Then the brain starts pruning. The brain starts shrinking. You're actually learning by failure.""

    Using a CEO of a finance company quoting neuroscience doesn't really add to an argument. Research in the last few years has proven that to be incorrect. Lots of books written on the topic in the last few years. (Spark by John J Ratey is one I'm reading now)

    But I nitpick - good read otherwise!

  • Report this Comment On February 26, 2014, at 8:21 AM, fbusnel100 wrote:

    Morgan

    beautiful writing. It's a good cause for reflection.

    ,,,and every day let's "Watch someone hold a cat by the tail" to learn...

    ciao

    Fulvio

    (from Italy)

  • Report this Comment On February 26, 2014, at 8:58 PM, SkepikI wrote:

    <The silver lining is that I learned my lesson. I will never make this mistake again. Experiencing it made me a better investor.>

    One can hope, but not always guarantee this outcome. Once in a while, Morgan, I've said this only to be lured in again by the random "oh what the hell" thought it just might work this time. Once, it actually did! For a bit, and I got out fast enough to avoid the collapse, make money when I realized just what I had done. Discipline is, well, hard.

    I've always thought financial "scar tissue" that looks fresh to me was the best insurance from a repeat. One reason I follow the Bitcoin story.... not because I am ever interested in obtaining some.

    One of the things I've also learned Morgan, is that attempting to "Beat someone or something" no matter if its a person or an index is a risk magnet and not always in a good or disciplined way. Just try to make some money. That can be hard enough in some environments. Like 2007-2011. If you can do that one simple thing, so what if you only earned 15% when the index was up 20? you still made money.

    As my Dads broker, my first, put it: "you'll never go broke taking a profit. You can't hit the high and you can't hit the low...LET SOMEBODY ELSE MAKE SOME MONEY!"

  • Report this Comment On February 27, 2014, at 12:28 AM, taloft wrote:

    Nothing quite like doing a face plant to teach you to watch where you're going. It doesn't mean you'll never fall down again but, I bet you do it a lot less these days.

  • Report this Comment On February 27, 2014, at 8:49 AM, Lyle1969 wrote:

    Good article.

    Another point: Maintain an operational awareness that you can make investment mistakes.

    All of us have made mistakes, but sometimes we forget that we can do it again.

    I've never sold one stock I lost 97% on. Now, every time I go to adjust my portfolio I 'm reminded of my own fallibility.

    It's probably saved me quite a bit over the last few years.

  • Report this Comment On February 28, 2014, at 9:47 AM, jlclayton wrote:

    Lyle1969, I know exactly what you mean. I dabbled in penny stocks about 10 years ago, lured by some friends who had made money investing is several of them. Of course, after seeing some terrific profits, the bottom dropped out of them and I lost several thousand dollars, which was about a quarter of my portfolio at that time. I finally sold all at over a 95% loss except for one, which I keep to remind me how foolish I was when I first started investing. Every time I look at my portfolio I see the 99.99% loss.

    Luckily, that experience is what forced me to start learning much more about sensible investing and wealth building, and that led me to the Motley Fool. I consider my losses as a cost of tuition for my financial education and keep reading articles like this to stay on track and remember that I will never be infallible.

  • Report this Comment On March 01, 2014, at 11:33 PM, Mykiemon wrote:

    Thanks Morgan, an informative article that espouses tenets I pay attention to but will pay more attention in the future.

    Fool on,

    Mykie

  • Report this Comment On March 03, 2014, at 1:18 AM, vgunge wrote:

    Really Nice article.

    I love the first HEADING a lot.

  • Report this Comment On March 03, 2014, at 7:03 AM, colincmacfarlane wrote:

    Hi Morgan,

    I have seen people making lots of mistakes through their lives. At times I laughed at their stupidity, how come people make such mistakes: " I will never do the same thing". It was not until I faced the real situations, my situations and I realized I am even more stupid than them. There are things we have to experience ourselves to learn I guess...

    Having said that, totally admit the benefits of learning from others' mistakes.

  • Report this Comment On March 03, 2014, at 8:18 AM, Marshalldedr wrote:

    Following an investment that an "expert" is making without knowing the entire story is no different than following someone that made a poor investment. We do not know why the investment failed for them. So I am not sure how watching other's make mistakes can teach us unless we know ALL the parameters of the occurrence. If even one aspect isn't know we would not understand the full picture correct?

  • Report this Comment On March 03, 2014, at 10:18 AM, Mega wrote:

    Morgan,

    What was the specialty lender you invested in that went bankrupt?

    Personally I don't get much new information out of behavioral finance, which basically just repackages Buffett and Munger's common sense. I find specific information much more useful.

  • Report this Comment On March 03, 2014, at 1:00 PM, foolishlycuriose wrote:

    Living vicariously to learn by another's mistakes reminded me of an interesting quote by Albert Einstein: "Anyone who has never made a mistake has never tried anything new." Whilst I agree wholeheartedly with your idea, I had to (unfortunately) make my share of mistakes to become a better investor, which I define as being more objective and business-like rather than lucky although I don't mind the latter when it happens.

  • Report this Comment On March 03, 2014, at 1:31 PM, JohnnySimpleton wrote:

    I respectfully disagree. You can learn how to invest like Warren Buffet and simultaneously learn how not to invest like the Lehman Brothers. It's not what a legendary investor invests on I believe it's more so how they invest. What dictates there logic behind their investment and how can you apply it to tailor your own individual needs. Ex: Warren Buffet learned to apply the ideals of Benjamin Graham but he isn't a Benjamin Graham clone he was his own individual that produced his own wealth through the,lessons he learned from Graham.

  • Report this Comment On March 03, 2014, at 4:23 PM, umpire777 wrote:

    I love the line from Mark Twain.

  • Report this Comment On March 04, 2014, at 12:26 AM, RxPro wrote:

    A lot of things you have to learn on your own. Especially in more complicated strategies like options. Of course you can go your whole life never purchasing or selling an options contract, but if you want to learn it, be prepared to lose a lot before you start to make money.

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