We all have a hard-wired aversion to failure, especially when it comes to matters of money and investing.
But failure is a natural and necessary part of learning – there is no impetus to improve one’s skill in a given field if one does not first try their hand at it, and there is no way to try something new without meeting with a few setbacks.
A recent TED Talk, given by an executive at an unnamed but easily-recognizable technology giant, talks about the importance of not just accepting failure, but celebrating it. Under this man’s leadership, celebrating failure means not just telling employees “It’s okay if this one doesn’t work out,” but involves offering bonuses and paid vacations to teams who continually push projects to flame-out.
He maintains that the main reason why his “Moon Shot” development group produces outstanding innovations is that its culture encourages people to come up with bold ideas without fear of the dreaded seven-letter F-word.
But not all failures are created equal. Bad failures are ones in which nothing was learned because the project wasn’t set up to enable learning in the first place. Good failures are those from which you develop a skill or insight that can be extended to another problem.
Failing in investing is as important as it is for an innovative tech start-up, but I think that most investors fail badly. They fail badly because they don’t know what to focus on, get frustrated when an investment doesn’t work out immediately, and allow unreasoned fear and greed free rein to influence decisions.
They make investment decisions based on this newsletter or that pundit, mostly without understanding even the most rudimentary facts about how the company purports to generate value for its owners. To them, failure is determined by the fickle action of market prices over a time horizon that is usually much shorter than their natural investment time horizon and certainly too short to be able to say much about the firm’s capacity to generate value. Because they fail badly, they learn nothing, so there is no way to ever become more skillful.
While failures are unavoidable in investing, avoiding bad failures and learning from good ones is key. I believe that good investing failures require a few elements:
A simple, measurable hypothesis that is not connected to the market price of the stock. Stock prices fluctuate for many reasons, including the fickle, contrasting tug-of-war between fear and greed. Rather than base an hypothesis on short-term price fluctuations, we believe it is best to form hypotheses about the drivers of value itself. For example, “I think this company should be able to generate revenue growth averaging between 2% and 5% over the next five years.”
Clear, unambiguous criteria to determine success or failure. The hypothesis above sets out a clear success criterion. If the company loses an important client and revenues drop by 20% without chance of a replacement client for the foreseeable future, you know that your projection about a fundamental driver of value has failed.
The willingness and ability to compare observed results against your hypothesis. Setting unambiguous criteria based on valuation drivers is a good start, but you would be amazed to see how many professional investors and analysts refuse to objectively assess actual results versus expected ones. Poorly-designed financial models are so complex that the investor can easily fool themselves into thinking their assumptions are correct.
The ability to trace back the root cause for the error in judgement and to have the capacity to not make the same mistake again. Knowing why you failed and how not to make the same mistake in the future is the real payoff of a good failure.
It’s worth pointing out that investment failures do not always involve losing money. Understanding when you got lucky and why is one thing that an investor who cycles through bad failures will never be able to do. Also, it is important that allocating assets in your portfolio in such a way that a failure – good or bad – does not break the bank. You may hold the hypothesis that a small cap retailer in danger of bankruptcy can make it through the crisis and create a great deal of value for its shareholders in the future, but betting 90% of your portfolio on that hypothesis is not prudent, no matter how the investment ultimately works out.
Fail often and fail well. Good failure is the key to investing success!
This article original appeared on Erik’s blog at Forbes.com