According to author and journalist Kathryn Schulz, being wrong doesn't feel all that bad. It's realizing that we're wrong and the emotions that come with it that feel bad.
In a talk at a TED conference earlier this year, Schulz presented an interesting perspective on humans' never-ending quest to avoid being wrong and our ability to dismiss everyone who disagrees with us.
This is hardly foreign to investors since "wrong" seems to be a bad word in the world of finance. That's actually pretty funny considering that investing great Peter Lynch openly admitted that even the best investors are typically wrong four times out of 10. But what does he know?
Being OK with being wrong
Obviously, being wrong isn't ideal for an investor since it generally means that you're losing money. But I can think of at least a few reasons why it's better for investors to embrace the idea of being wrong rather than fight it.
Those reasons include:
- The herd is not your friend. If you want to beat the market, you're going to have to part ways with the crowd. However, if you're concerned about being wrong, it's more likely that you'll seek cover in the crowd because then, if you're wrong, you can hide behind "Well, everyone else got it wrong, too."
- Time is not on your side. If you're wrong about a stock you bought, it's very likely that the longer you wait to admit to being wrong and kick that stock to the curb, the more money you'll lose.
- A teachable moment. Some of my best investing lessons have come from some of my biggest mistakes. Investors who refuse to acknowledge their mistakes miss out on these great opportunities to learn.
But when are you wrong?
The problem, of course, is that it's easy enough to say that it's important to own up to being wrong when you're wrong. But the bigger problem is often recognizing when you are wrong.
Many traders will say that you're wrong when the stock moves against you. But that's not helpful at all to value investors like me since I'm often looking at stocks specifically because the stock is falling and other investors (traders?) are abandoning it.
Flip it
Putting the question on its head can help: How do you know when you're right? When buying a stock, an investor should have some view as to why they're buying the stock. This could include how much they estimate the company will grow, a prediction that market sentiment will improve and land the stock a higher multiple, or the expectation that a steady stream of dividends will lead to attractive returns.
From there it's much simpler -- with a view toward what would make you right about the stock, you can more easily pinpoint when you've been proven wrong.
How it works
So what might this process look like? Let's take a look at a few examples.
Investors are currently paying a big price for Motley Fool Stock Advisor recommendation Netflix (Nasdaq: NFLX). Why? Because they think the company has advantages over potential competition and that there's still plenty of room for growth. With that investment thesis, "wrong" starts flashing if it becomes apparent that competitors can step in and easily take customers from Netflix or the company's growth slows drastically.
CenturyLink (NYSE: CTL), meanwhile, is a favorite among investors with a taste for fat dividends since it currently has a 7.4% yield. As a landline communications company, heady organic growth isn't likely in the cards for CenturyLink. Investors do, however, love the copious cash flow that CenturyLink produces and generously pays out through dividends. Investors banking on these dividends, though, may need to be ready to consider the "w" word if the company's cash-producing ability suddenly diminishes or it decides to commit its cash to something other than dividends.
While both of the examples above concern how the future affects your original investment thesis, sometimes you may realize that there was something that you missed in your original view that makes you wrong. I ran into exactly that when I bought Bank of America (NYSE: BAC) in the years before the financial meltdown.
As I followed B of A and got to know the company even better, I became increasingly concerned about its CEO at the time, Ken Lewis. I ended up thinking that Lewis simply wasn't a good operator -- something I should have figured out prior to investing. At the point I figured this out, I still had time to admit that I was wrong and get out. But alas, I didn't -- and the losses helped burn the lesson into my brain.
Set yourself up to be wrong
Having the humility to admit when you're wrong is an important trait for an investor, but as I've outlined above, you'll have a tough time ever figuring out if you're wrong if you haven't first outlined an investment case for each of your stocks.
Being wrong will never be fun, but as long as it's going to happen -- and it will happen, trust me -- why not try to minimize the cost and maximize what you can learn from it?
Motley Fool co-founder Tom Gardner was wrong about these stocks, but fellow Fool Seth Jayson takes away an important lesson from those misses.
