Pondering on one of the most important topic in investing “Mistakes”
In this edition of learning of the week, we are going to touch upon a crucial topic, both from an investing as well as one’s life perspective. Today, we are going to talk about MISTAKES.
Here is what we are going to cover: Initially, we will divide mistakes into two categories. We will try to put the same in investing context, followed by which we will use hypothetical numbers to understand which out of the two types of mistakes one should focus on controlling as an investor, and eventually we will understand the sheer importance of a single most important learning that our investing heroes have been imparting us since many years. So let’s dive in…
Quick Note Before We Begin
This isn’t an original idea. What follows is a blend of lessons we’ve learned from various mentors and heroes over the years. We’re deeply grateful to all those who’ve shared their wisdom about mistakes-lessons that have stood the test of time.
Mistakes: Life’s Inevitable Companion
Mistakes are simply part of being human. Whether in our personal or professional lives, we make so many decisions that keeping count is impossible. Yet, life doesn’t always penalise us for every misstep. Sometimes, mistakes lead to unexpectedly good outcomes. If you zoom out, you’ll notice most mistakes fall into two buckets:
a) Choosing something you shouldn’t have – For simplicity, let’s call them Type I
b) Overlooking something you should have chosen – let’s call them Type II
The above framework applies perfectly to investing.
Categories of Mistakes – Type I vs Type II
Remember your friend or relative talking about the stock that he/she spotted very early but didn’t choose to invest in for some reason? That they are sharing their emotional pain with you of committing a Type II error.
Believe it or not, life can be incredibly kind. We’ve all had moments where a mistake goes unnoticed, and things work out just fine. In investing, this happens more than we think. If you pride yourself on your intellect, this truth might be tough to swallow, but it’s real.
We are all aware that many of the handy things that we use today are the result of mistakes. Take penicillin, for example, or the Post-it note or the internet, with the help of which we are communicating with you today. These are very few of the plethora of examples communicating that “Many times, life is kind.”
To exemplify the kindness of life the investing context, let me cite an example of my uncle. He had no experience with equities but owned shares in Satyam Computers before the infamous scam. During the dot-com boom, he checked his investment and found it had multiplied enough to buy a house in Mumbai. He sold his shares, bought the house, and found stability. The stock went higher, but he was content. While many lost money in Satyam, he was one of the lucky few who benefited from a Type I error or very simply, the kindness of life.
Teachings from Warren Buffett and Nature
We all know and acknowledge that we are going to make a lot of mistakes as investors, and fortunately, we are not going to get penalised for all of them. However, as investors, it is our “Dharma” to strive as hard as possible to commit as few mistakes as possible (don’t know how to quantify that, but I am sure you get my point.) Thankfully, Warren Buffett and Nature have very clearly laid it out for us as to which mistake we should try to reduce more.
Warren Buffett has famously quoted two rules of investing: “1) never lose money and 2) never forget rule #1.”
Nature, however, doesn’t speak but gives the same learning very subtly; we just need to be observant. Borrowing learnings from Mr. Pulak Prasad’s book “What I learned from Darwin about Investing”, he very clearly explains how nature has created plants and creatures in such a way that they also try to reduce “Self-inflicted” damage as much as possible.
If you live in India like us, you are sure to be used to witnessing street dogs and their fights. But do you know their modus operandi? Well, I am sure subconsciously you know it and will recall as you read the next few lines.
The behaviour you’re describing in street dogs is a classic example of how nature encourages animals to minimise self-inflicted damage through ritualised displays and communication, rather than immediate physical confrontation. When two street dogs encounter each other, especially over territory or resources, their first instinct isn’t to jump straight into a fight. Instead, they use a series of visual and vocal signals, like barking, growling, raising their fur, and baring their teeth. Here’s why this matters:
The same principle is seen across the animal kingdom, whether it’s deer locking antlers, birds performing threat displays, etc. This strategy, show before you strike is a natural, efficient way to reduce self-inflicted damage and promote survival.
In short, both Warren Buffett’s quote and Nature’s evolution teach us to reduce “Type I” errors in life, and investing. We must try our best to avoid investing in companies where we may lose money in the long run.
The legendary Indian investor, Late Mr. Rakesh Jhunjhunwala, put this nicely by saying, “I am not afraid of making mistakes. But my mistakes were those that I could afford. That’s very important: mistakes will happen, but you must ensure that you keep them within limits you can afford.” In other words, if you manage to survive during difficult times, there will be an opportunity (mostly) where you can thrive.
Mathematical Understanding: The benefit of reducing Type I error in Investing
The best investors aren’t just good at picking winners; they’re amazing at avoiding losers. I am sure I am not the first one to communicate this to you. However, let me help you crystallise this thought by using numbers on the same lines as presented by Mr. Pulak Prasad in his book.
To start off, let’s make THREE assumptions,
a) There are 4,000 listed stocks in India.
b) Out of these 4,000 stocks, only ~25% (1,000) are worth investing in.
c) You have an 80% success rate. Meaning, if you come across a bad investment, you will reject it 80% of the time, and if you come across a good investment, you will accept it 80% of the time. In short, your rate of making both Type I & II errors is 20%.
Now, if you are congratulating yourself for the 80% success rate, let me request you to hold your horses and first calculate your success rate with me…
There are 1,000 good investments worth making, and since you have a tendency to reject 20% of the good ideas (Type II error), you will end up selecting 800 good ones. Additionally, the market also has 3,000 bad investments, and you also have a tendency to accept 20% of bad ideas (Type I error), you will end up selecting 600 bad ones. Hence, your probability of making a great investment is 57% (800 / (600 + 800)). In other words, despite being right 80% of the time, 43% of the investments that you make will turn out to be bad!
Now, let’s build two cases. In case a), you try to focus on minimising Type I error by 10% and in case b), you try to focus on minimising Type II error by 10%. Below table summarizes the new outcomes.
In case a), where you decide to become a better rejector and say NO more, your winning % jumps significantly from 57% to ~73% whereas in case b) where you decide to focus on not missing out on good opportunities your winning % only sees a minor improvement from 57% to 60%. The above calculation presented by Mr. Pulak Prasad gives us a very strong insight into the fact that the relative impact of reducing each type of error is quite distinct.
But wait. I am in the equity market to take risks…
This is a reply you may often receive if you talk about reducing Type I error to many investors (especially guys who entered markets post-COVID). Theoretically speaking, they are absolutely right. As an equity investor, you are taking the most risk, and since you have signed up to be in equity markets, the capital that you bring here is for nothing but taking risks.
This reminds me of the famous quote by Yogi Berra, “In theory, there is no difference between theory and practice, but in practice, there is.” The catch that these investors are missing is that the fundamental relation between risk and reward taught to us in finance classes, “high risk = high reward”, is flawed. The fact of the matter is slightly elaborated, taking high risk doesn’t guarantee high return, what it guarantees is a high variability of return on either side. Putting it even more simply, if you make a risky investment like equities, the only thing it guarantees is that the outcome that may eventually come out can vary over a wide range vs a significantly less risky investment like FD, where the outcome is fixed. Here is how the graphs look.
Thankfully, equity investing, due to the volatile nature of markets, often offers opportunities that offer “Positive asymmetric risk-reward,” a situation where the potential gain far outweighs the potential loss. But the tricky part is that we must strive hard to find such opportunities, a work that not many investors are willing to put in.
The Emotional Cost of Saying “No”
Focusing on reducing Type I errors means you’ll pass on many investments that might turn out great (Type II errors). That’s emotionally tough. You’ll need to be comfortable with missing out and learn to separate decision quality from outcomes, since luck sometimes saves us from ourselves. It is important for us to keep assessing our decisions honestly and not confuse luck with skill.
So with this, let’s wrap up with a quote from the late Indian investing legend, Mr. Rakesh Jhunjhunwala, “Investing is not an act of smartness. It’s an act of wisdom.”
Wishing you a wonderful weekend and happy investing!
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Happy Investing!!!
Disclaimer: These insights are based on our observations and interpretations, which might not be complete or accurate. This newsletter is for educational purposes only and is not intended to provide any kind of investment advice. Please conduct your own research and consult your financial advisor before making any investment decisions based on the information shared in this newsletter.
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