6 Billion Errors Per Day, Minimum

A few weeks ago, I mentioned we were 50% long, 50% cash, and were planning on selling into any rallies. Since then, we have sold some winners outright (PWER), cut back other positions, and been stopped out completely of losers; win some, lose some. We are now approximately ~85% cash.  

The reason I bring this up was to share with you two reactions I got when describing these recent trades and cash holdings. I had two separate conversations in July — one with a well known Trader, the other with a Fund Manager (known in the industry, but not a household name) — about our posture prior to yesterday’s drop.

The two responses were polar opposites, 180 degree apart.

The trader respected the discipline of honoring stop losses. Good traders know that opportunistic speculation is a process. Ignore any one single outcome, focus on the methodology that can consistently avoid catastrophic losses, manage risk, preserve capital. A good process can be replicated, a random spin of the wheel cannot.

The fund manager, who was having a decent year being long high vol names (at least before Wednesday), was having none of it. “Stops are for losers” is a quote I shall long remember (and email him after he blows up). Apparently, real men have the courage of their convictions.

These two conversations were in my mind when I stumbled across a post at the Less Wrong blog; its a site dedicated to “refining the art of human rationality.” One of the things we humans do is come up with short cuts, heuristics — experience-based techniques that help in problem solving, but often contain unwarranted assumptions.

The post Five-minute rationality techniques mentioned a quote we are all familiar with: “It takes a big man to admit he’s wrong.”

Stop to consider that quote for just a minute, and you will realize how silly it is. If we are honest with ourselves, we will have to admit that all of us are wrong about something every single day. The daily details of life are filled with our own errors: What will happen today, the best route to take to work, anticipating a colleagues reaction to something, the weather, etc.

To investors, we are just as wrong just as often, even on the big things: An assumption we made about a major issue, a small but crucial fact we misremember, a forecast we made 6 months ago — all wrong. Expectations for earnings, econokic reports, how the markets behave.

Rather than fight our foibles, people should admit this error stream is real, and repair the errors of our ways as soon as we discover them. I have noticed over the years the difficulty some people have in cutting losses, admitting an error, and moving on. Way back in 2005, I wrote a piece advising investors that they should Expect to Be Wrong (originally published 04/05/05). I noted that “I am rather frequently — and on occasion, quite spectacularly — wrong.” However, if we expect to be wrong, then there will be no ego tied up in admitting the error, honoring the stop loss, and selling out the loser — and preserving the capital.

Which brings us back to the hubris of the aforementioned fund manager. I see three error related problems: 1) He is focused on short term outcomes, rather than longer term processes; 2) He does not believe he is wrong, or apparently, deluded himself into thinking he can be wrong; 3) He is unaware of his own meta-error.

This is a recipe for investing disaster. We humans make 6 billion errors per day, at the very least. The biggest one is not acknowledging this simple truism.

~~~

BTW, the headline of this post is wrong. There are 6.69 billion people on earth; we should reach 7B sometime in 2011. The management apologizes for the error . . .

Previously:

How Blind Are We to Our Own Shortcomings? (December 26th, 2005)


Originally published at The Big Picture and reproduced here with the author’s permission.
 
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