Baruch came back from a lovely long holiday to find he may have been totally wrong in his last post about Apple. Embarrassingly, fist-bitingly wrong, in a 100%, black-is-white sort of way. He thought the new iPhone wouldn’t sell, as the new features on the new one weren’t, according to him, worth the upgrade. Wronggg!! Apparently old iPhone 3G is selling so badly that Apple is transferring all production to the 3G S, and taking the old iPhone off exclusivity in certain markets. Business has never been so good. It is early days, to be sure, and perhaps the situation will reverse itself. But right now the conclusions of my last post, however cogently argued, simply don’t hold water. In fact, the opposite seems to be happening.
This is good opportunity to ponder on what it means to be wrong in an investment context.
Now for many people, being this wrong would be a bad thing, more than anything because it looks embarrassing. If Baruch was some sort of pundit or commentator, or a full time blogger, he might be tempted to brush it under the rug and pretend it never happened. Or cavil it away (I never meant that . . ), or launch an ad hominem attack on the source (in this case a well-connected analyst at a big bank, via his salesman; trust me, these people are used to ad hominem ). Certainly some in Baruch’s audience will be disappointed, and possibly not take him seriously again. “Cancel my subscription, sir!” Competing commentators will rub their hands. In a media context there are no prizes for error.
However in dealing with the real world, and in an investment context, being wrong is often the best thing that can happen to you, providing a) you recognise it, and b) you have left yourself in a position to do something about it. First off you can cut your losses; bravo! You have been falsified!
When a position doesn’t work or is falsified (say, your invasion of Iraq isn’t going well), if you remember that you were just positing a thesis and knew you were probably wrong, you can flip it without a second thought. Many hold on when they shouldn’t, ashamed to admit error, desperately seizing on any item of good news, racking their brains to find reasons why the bad news isn’t actually bad, while all the while forgetting they should just sell. This is a recipe for losing lots and lots of money. I used to make this mistake a lot and, very rarely, sometimes still do. Of course, you let your winners run.
More important, though, is to make sure ahead of time that you’re in a position where you CAN sell, and before you get in, to set out the conditions under which you’ll know you’ve been falsified. This is the oft-mentioned “stop-loss” level. For your stop to work without losing too much money you’ll need to be in something liquid, and this means, most probably, not using a lot of leverage. There’s nothing worse than knowing about its impending doom, but owning so much of a position that selling would bring about the very collapse in price you would be trying to avoid by selling. Ask the guys at LTCM.
But the most important thing about being wrong is this: you now have very clear, new information for a new series of potentially much more accurate logical deductions. Eliminating potential outcomes equals more conviction in the ones that remain; you can place more money on this bet, so the payoff may be much bigger than what you lost in the first stage of being wrong. Having thought through the erroneous trade in the first place, you may be analytically one step ahead of those who are only just starting out. You may be able to react much faster than they to the new piece of information and its implications, and maybe enter your new position before the price has time to react. Your post-error trade may end up making you more money than the original trade would have if it had actually worked!
This is what experienced traders mean when they talk about “knowing how to take a loss”. For a concrete example, why not take the one at hand? Knowing now that Apple is cleaning up in the smartphone market with new product likely means, firstly, that AAPL is going to print better gross margins when it reports (this actually happened I think). Cover any AAPL short, go long. It’s extra bad for all the players who have been hurt by Apple since iPhone 3G came out. Nokia and Motorola spring to mind. But you may also guess that the smartphone market may not be very price sensitive, and cares about phone specs and software. Find players with well-specced alternatives. Think that PALM maybe has a shot. Be suspicious about the budget end of the spectrum; low end smartphones (Nokia’s supposed 2010 strategy) may be as attractive to discerning punters as discount sushi.
More money is lost through shame and the compounding of error that accompanies it, I think, than through merely being wrong. Our emotional need to appear smart in front of our bosses, peers and colleagues is a major handicap to proper investing cognition. If during working hours I could temporarily disconnect the areas of my brain where emotion resides, I am sure I would make more money. A further conclusion is this: put yourself in a position where you can make errors. Don’t worry too much about whether to put on a trade; if you have thought it through a bit and have a price to stop it at, do it. If you are still worried, do it in small size. But do it. We learn our best lessons through mistakes. As a great man of Baruch’s acquaintance put it:
In life, and in every form of endeavour, there is the possibility of mischance, error and futility. But merely to avoid the attempt because certainty is impossible to achieve is to be inhibited by an immaculateness so overwhelming that nothing will ever be accomplished.