One of the hardest parts of investing is finding the balance between:
- Riding out periods temporarily unfavorable to your views.
- Realizing your views are wrong and moving on.
It's the difference between patience and stubbornness, and can separate the ruined from the rich.
Bill Ackman shorted (bet against) Herbalife (NYSE:HLF) stock more than three years ago. It hasn't worked out. Shares rose 50% last year, and are 35% higher than they were when he revealed the short in 2012.
But Ackman is resolute. The market doesn't understand Herbalife's business model, he says. He does, because he and his analysts spent years scouring the company. The Wall Street Journal reported (emphasis mine):
After publicly coming out against Herbalife in 2012, Mr. Ackman says he has spent more than $50 million to research and publicize his fund's negative view of Herbalife. He has hired a team of lobbyists and consultants to contact a host of politicians and regulators and encourage investigations into the company.
Fifty-million dollars in research costs and three years of due diligence for one company. That's real money, even in hedge fund terms.
I have no idea if Ackman is right. But I know it would be hard to admit being wrong after sinking that much time and money into one idea. The pressure to ignore anything that goes against what you're trying to prove would be tremendous. It's fuel for stubbornness, because admitting being wrong is an admission of years of wasted effort. And that hurts.
This is a big problem in investing. Analysts want to be thorough, digging deep into their investments to understand businesses and theories. But effort can repel open-mindedness, which may be more dangerous than putting in no effort at all.
It's easy to convince yourself of something you desperately want to believe. You can cling to data that shows you're right and ignore information that shows you're wrong, especially if you've already sunk effort into one conclusion. This can not only make you wrong, but wrong and confident, which is disastrous. Humans are the only creatures that can do this. In their excellent book Mistakes Were Made (But Not By Me), Carol Tavris and Elliot Aronson write:
A dog may appear contrite for having been caught peeing on the carpet, but she will not try to think up justifications for her misbehavior. Humans think; and because we think, [we tell ourselves stories and] our behavior transcends the effects of rewards and punishment and often contradicts them.
Charlie Munger once described what happens when you can't let go of your cherished beliefs:
Failure to handle psychological denial is a common way for people to go broke. You've made an enormous commitment to something. You've poured effort and money in. And the more you put in, the more that the whole consistency principle makes you think, "Now it has to work. If I put in just a little more, then it 'all work." People go broke that way, because they can't stop, rethink, and say, "I can afford to write this one off and live to fight again. I don't have to pursue this thing as an obsession in a way that will break me."
How do you avoid this trap?
It's so difficult. But here's an idea to help reduce errors: Avoid investments of such vague appeal that a team of Harvard MBAs needs three years and $50 million of research to get to the bottom.
I see people whose investment beliefs rival religious passion. They believe so strongly in their views that they literally can't understand why you'd disagree with them. The basis of their passion is usually years of deep study, which creates the impression of expertise but may actually just be a supernova of confirmation bias and self-delusion. "Expertise is great," investor Dean Williams once said, "but it has a bad side effect: It tends to create an inability to accept new ideas."
The key is realizing there's a difference between favorable odds and effort. In 1996 Munger was asked what kind of discounted-cash-flow models Warren Buffett creates before investing in a company. "I've never seen him do one," Munger said. Buffett chimed in: "It's true. If a company's value doesn't just scream at you, it's too close." Once deep calculations are needed, you're running down the path of confirming whatever you want to believe, often because you want your effort to be justified.
Many of Buffett's best investments happened quickly, a matter of days between discovery and writing a check. That's partly because he's been investing for 70 years, so lots of information is accessible off the top of his head. But it's also because he makes an investment only when the idea is so clear and obvious that complication isn't necessary.
You and I aren't Warren Buffett. But the logic of only moving when things are blindingly clear is something we can all learn from. The clear ideas are the ones you don't become emotionally attached to because you haven't devoted your life to them, but still have a decent shot at good performance over time. Stocks will do better than most other assets over time. Costco (NASDAQ:COST) provides a service people love. Capitalist economies trend toward progress. These ideas are obvious and have a high chance of being right, but no one needs to spend years of research to confirm that they're right, so you're not wedded to them for life and can change your mind when the facts change.
Psychologist Phil Tetlock spent his career studying people who are legitimately good at forecasting. One trait that consistently pops up: The ability and willingness to change your mind when the facts change. And a trait common in people who make awful forecasts? Extreme devotion to one big idea.
None of your views should be so cherished that you won't abandon them when the facts change or learn something disconfirming. The world changes, and nobody knows a fraction of what's out there. As soon as someone commits their life to one big idea, they'll believe it no matter how wrong it may be.