1 mistake I made and 7 easy tactics to make better decisions in investing
Investing is all about decision-making. There are 6 possibilities:
You buy
You sell
You hold and do nothing
You add
You trim
You pass
We often forget that this third one, doing nothing or as Charlie Munger says, sitting on your ass(ets), is also a decision. Every time you decide to hold on is a decision. Nick Sleep, the ultimate holder of Amazon and Costco emphasizes this in his letters.
In this article, I’m looking for practical tools or actions we can take to improve our decision-making process.
In comes Annie Duke, a former world champion poker player. Over her career, she has won more than 4 million dollars in prize money.
Luck you say?
Matt Damon doesn’t agree:
"Why do you think the same five guys make it to the final table of the World Series of Poker EVERY YEAR? What, are they, the luckiest guys in Las Vegas?"
from the movie Rounders
There has to be something about the game of poker that it is more than only luck.
As the best poker players say: It’s all one long poker game.
You can win some games, and you can lose some games, but over the long run, your goal is to win the long game. This holds in investing, whether you are a trader or a long-term investor. If our long-term goal is wealth creation, then it’s okay to lose from time to time.
We just need to be right more than we are wrong, and just like professional poker players, play the long game. Let’s dive in to see what tactics we can deploy.
Luck vs skill
Dumb luck
Investing is hard. I put hours and hours into it, reading, and learning iterating to improve my skills when at the same time, my nephew, who is 10 years younger, bought Tesla 5 years ago and made a killing. He does not invest his time to learn more about this investing game. My nephew admits that there was a lot of luck involved.
The luck factor will always be a big factor when we invest in the stock market. It’s the same thing during a poker game. You can be the best player, but if you’re dealt several bad hands in a row, you can still lose. But the goal is to win in the long run. One battle lost does not mean you’ve lost the war.
The danger here is to confuse skill with luck. If we win, it’s because of our superior skill, if we lose, we were unlucky. We tend to correlate the outcome to the decision. Our goal should be to improve and to learn the right lessons. You can lose big in the market on a good decision, and win on a bad decision. How are you going to distinguish between them?
What we want is this:
We want to make sure that we can learn from our investment outcomes and adapt our decision-making process accordingly by separating luck from skill. One caveat in this process is the cycle time. It will vary, but if you invest with a multiple-year view, it will take time for the cycle to complete.
Michael Mauboussin wrote an entire book on untangling luck from skill (The Success Equation).
We can look at it like this:
My nephew didn’t have a process when he bought TSLA. The outcome is just dumb luck. He admits this. Our goal is to make sure our process is solid. Sometimes this will lead to success other times we will get bad breaks.
A practical solution
So what can we do in practice to learn and improve our process? What works best for me is writing down my reasoning for my decisions. This can be buying, passing, or any of the above.
For each investment, we can write down why we invest. What is the thesis, the hypothesis and what are the parameters that we are going to track to confirm or break this hypothesis?
But we can go further. If we pass on an investment, we write down why. If at a certain moment, we feel the urge to act and decide to do nothing, we can write down why we made that decision.
This means journaling and writing down our reasoning before making any decision related to your investments. If news comes out on the company you’re following, you can add relevant data points to your tracking document.
Tactic number 1: Journal and write to asses your decision-making process. At the moment, I’m just using Google Docs to track my process, but I’ve recently discovered an app, Journalytic.com (no affiliates or anything) that might make life easier. It’s in BETA and free at this time.
I need to use it some more, but what’s interesting, is it calculates the opportunity cost automatically if you decide to pass or sell. This can be very interesting a couple of years later when analyzing the bets you made and didn’t make and verifying if your decision-making process is robust.
Here’s an example of a decision to NOT buy Apple.
And an overview of the actions you’ve taken with the related opportunity costs:
Thinking in bets
What most investors do, is calculate a price that they think a stock is worth, and compare it to the price in the market (at least I hope they do). If their value is higher than the price, then they might decide to buy.
Even better would be to acknowledge there is significant uncertainty or error in the calculation of the intrinsic value. This uncertainty increases if you’re using a discounted cash flow model (due to the exponential nature of the functions used) and if the company is still young and growing fast (which makes it harder to predict the future).
To compensate for this uncertainty, we use a margin of safety. This allows us some margin for error.
But how will you handle uncertainty in a stock portfolio? Or opportunity cost? You’ll need to think in probabilities, in bets.
Here’s what I started doing, and I try to avoid complicated statistical distributions (hello Monte Carlo) to keep the process as simple as possible. You will see this approach in the previous articles on Inmode, Dino, and Adyen.
What does the downside risk look like?
What does the upside potential look like?
What is the probability of both occurring?
Is the company exposed to optionality, to additional luck?
And finally, based on these 4 criteria, rank the different companies in your portfolio.
Let’s make it more visual. We define 5 levels of probabilities as such:
We have the probabilities of a positive upside, and we have probabilities for a downside or loss of capital.
I haven’t defined specific values on purpose. Based on the quantitative and qualitative analysis you do on a company, and after analyzing numerous companies, you’ll generally know which probability to assign.
Let’s use Dino Polska as an example:
Dino’s Upside Potential and Probability
In my previous write-up, I considered the long-term potential for Dino Polska to be about 5x. Because of the MOAT DINO has, and because the market is so fragmented which means they will gain market share from the mom-and-pop stores, I consider this upside probability to be very high.
Dino’s downside risk
The probability of losing my investment in the long term I think is very low. Dino is generating cash, and as Dino grows, it will have more and more scale advantages. I do not think this company can go bankrupt any time soon, and although prices can fluctuate in the short term, in the long term the downside is limited. They’ve reduced the debt on their balance sheet and as a retailer, have negative working capital.
The last factor is the upside optionality
The DNA of the company is that of a frugal operational excellence machine. They do try to venture into new revenue potential by adding gas stations to their stores, and they recently bought an online retailer to increase their e-commerce capabilities, but I consider the additional exposure to the unknowable upside as low.
Now our investment looks more like a bet in poker. We have the upside, the downside, and probabilities.
But all investing decisions are relative decisions. There is an opportunity cost. If you have a portfolio with 10 positions and are fully invested, you’ve made 10 bets. Each bet has a downside risk and an upside potential. They both come with different probabilities.
How can we compare these to each other, and what to do if we discover another company that seems like an even better bet? Which bet do we sell?
Let’s take a look at how I compare the different companies to each other. If I repeat the aforementioned exercise for the other 2 companies I’ve written about, I get something like this:
Imagine a portfolio of 3 companies. Repeating the exercise from before, allows me to rank these companies in the portfolio.
I consider Inmode as the lowest-ranked of the 3 because:
The medical devices market is highly competitive
I consider the downside probability as limited as Inmode has a very strong balance sheet and the market has priced in a no-growth outlook
The upside optionality is low. I rate it higher for Adyen because of the technological nature of the company and because innovation is needed to stay ahead of the competition. This innovation might lead to new business ventures unseen at this moment in time
When fully invested, if tomorrow I find a company with better criteria, I should swap the lowest-ranked company out of the portfolio. There is one caveat though: These are long-term potential and probabilities, if in the short-term, your stock drops 50%, you need to take that into account before swapping out a bet. These, to me, are the hardest decisions.
If you discover a company with a 10x potential and high upside probabilities, would you take the loss and place the theoretically better bet?
Tactic number 2: Think in bets. Assign probabilities to the downside and upside risk. Compare the bets to each other as investing is a relative game.
Joining an investing group
One way to improve your investing skills is to seek out and engage with other investors. This is a great way to learn from others preferably with more experience who share the same love for this game we play.
But there is one problem.
Confirmation bias.
Imagine you really like Tesla and you join to meet with other people who have also invested in Tesla. The main advantage:
If there is a significant price drop, the other people in the group can reassure you. Just stay calm, we’re in it for the long run. Stay the course!
Do not underestimate the power of this. We as humans are still mammals and very emotional creatures. A group can help us avoid emotional reactions and keep a rational thought.
But if the initial thesis is wrong, the entire group might lose its investments.
The goal is to find a group of people, that will say what they think, that will disagree if they think you’re wrong. The goal is to find the truth and to look for accuracy.
This is easier said than done. The most extreme example that comes to mind is the hedge fund of Ray Dalio where the organization is built on top of an idea meritocracy. Everybody shares what they think. They vote to get to the best idea. If you’ve put hours and hours into a thesis, for it to get destroyed, you will feel bad.
Tactic number 3: Find a group of experienced investors that do not always affirm the beliefs of the group. You need to be open to the fact that you’re dead wrong.
Risk management
One tactic poker players use, is to set a loss limit. If they are losing badly in a game, emotions can increase which could lead to bad decisions. Setting a loss limit avoids buying in more of the chips.
For long-term investors, we can relate this to setting a maximum position size.
Imagine you’ve developed a thesis for a company and you make a buy decision. A week later, the earnings call comes out, it’s a bit of a mixed bag, and the stock drops 30%.
You as a long-term investor may feel bad for a short period because you can feel the gut punch, but your rational mind is telling you this is an opportunity, to buy in some more.
There’s only one problem. In the weeks that pass, the stock keeps on dropping.
If your investment thesis is correct, you could be making a real killing in the long term. So you should be buying some more. But what if your thesis is wrong?
I’ve experienced this myself over the last month. I did my analysis on a company named Tinybuild (TBLD on the London Stock Exchange)
Here’s its stock price over the last year.
So Tinybuild has seen its stock crushed in the market. It did an IPO in 2021, rose to 3 GBP per share, and then dropped gradually towards the current price of 7.15 pence. A whopping 97% drop in share price.
I did my analysis, considered that the company has the means to recover, and got in. Here’s what happened:
I got in at 13.3 pence. Only a few days later, it dropped 30%. I felt that one. I discussed it with other people who were long (my group) and they reassured me to stay the course.
Since that moment, the stock has additionally dropped about 30%. This is the one big possible mistake I mentioned in the title. In retrospect, I had conviction, but I was too eager. I should have bought in small increments to mitigate risk. (when you feel eagerness over a stock, think twice before taking any action)
I could have bought some more but I stopped when I reached my max position size. This is a very simple way to manage risk. I’ll publish my TBLD analysis in the coming weeks.
And yes, at the current price, the stock needs to double, just to get my initial investment back. We’ll see how it goes, we’re only in the early innings.
And then I remember Matt Damon again:
"If you can't spot the sucker in your first half hour at the table, then you are the sucker."
Or as Buffet so eloquently mentions:
If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy.”
Maybe I am the patsy!
Tactic Number 4: Manage risk by setting a maximum position size. Be careful when averaging down. It might be better to average up!
Go long AND short
If in the previous example, our thesis on Tinybuild is wrong, then we will all lose some money.
What I should have done is go look for the people that have shorted the stock. What does the opposing view look like? What are the arguments they propose? I admit I didn’t do this enough for Tinybuild (I’m doing it right now). But I did do it for Inmode. I’ve written my long thesis and a bear case.
Looking at the bear case hasn’t made me change my position, however, it did help me track additional criteria to measure my initial thesis. So the bear case has been beneficial to my decision-making process in that if those parameters do not trend in the way I want it, I might sell sooner than expected and maybe avoid more losses. As Annie Duke mentions in her book, I calibrated my initial position.
If you happen to be on X, follow the people who disagree with your view. Have an open mind to analyze different arguments. It will help your investment decisions. More often than not, you will more likely not switch from your position, but you are going to recalibrate it, and make it better.
Tactic number 5: Actively look for the opposing point of view. Challenge your beliefs, it will refine your thesis.
All possible realities
You often see a bear and a bull case. Thinking in scenarios is pretty common in the investing world. But you less often see people assigning probabilities to these scenarios, as if both are equally probable. Developing scenarios and assigning probabilities leads to a probability tree. To construct one, it is best to start with the end in mind. What are the possible destinations where the company could land?
You can then calculate the expected value based:
If you think a 60% chance to win 100,000 dollars, then the expected value is 60,000
And a 40% chance to win 20,000 dollars has a value of 8,000.
In investing, it is hard to assign actual probability numbers to an outcome but the exercise in itself can be very useful as it forces you to think in bets. Second, in reality, only one outcome will prove to be real. The important thing then is to remember that the other probabilities existed in the first place. If you take a chainsaw and cut off all the branches of the tree then it seems the outcome was the only one possible. It’s all a game of probabilities.
Tactic number 6: Plan the future and think in scenarios with probabilities assigned to them
What’s your exit strategy?
The problem with the stock market is, it’s mostly liquid. You can enter a position and exit it when you want (except in microcap land). This is different in the private market.
If you buy a private company, you suddenly ask the following question:
Wait a minute, how am I going to get my money back? What’s your exit strategy you ask the CEO?
This could be:
An IPO
A buyout by a private equity firm or competitor
Some companies offer some degree of liquidity allowing the buying and selling of shares on other platforms
If an exit strategy is so important when buying in the private markets, it should be equally important in the public markets. At a certain moment, you’re going to want your money back.
Knowing when to quit and defining an exit strategy in advance will help rationalize and facilitate the decision-making process. Annie Duke wrote a whole book about it.
In the markets, most ‘losses’ are made when selling too soon especially if you’re investing in quality companies. Drawdowns of 30% or more are part of a normal pattern in price action. The ability to ignore price, and look at your exit strategy can help you to hold on to your investment for longer. And we know that holding on is the most difficult part.
The most important variables to track are the following:
Is revenue growing?
Is the competitive advantage stable or growing?
As long as this holds, you should be able to hold on. It’s up to you to define your own selling rules.
Final tactic: Define and write down an exit strategy for each position in your portfolio. Here, you can find my strategy for Inmode.
Summary
We’ve discussed several tactics during this article that should help us make better decisions in investing, many of which you may already employ. I recommend you read the book, Thinking in Bets, as it has some great stories to illustrate these concepts.
Here’s a short overview:
Write down your investment thesis to assess your decision-making process in the future
Think in bets, try to assign probabilities to your holdings
Join an investor group, to help you in times of crisis
Go long and short, the opposing view will help your understanding of the company
Think in scenarios and probabilities
Define an exit strategy, only buy when you know why you should sell
What other tactics are you using the avoid making bad decisions?
Further reading
Dig deeper by looking into the following resources:
https://www.theinvestorspodcast.com/episodes/annie-duke-podcast/
The success equation by Michael Mauboussin
Quit: knowing when to walk away by Annie Duke
This will not improve your investing skills but it is one of my favorite movies. Watch Rounders with Matt Damon and Edward Norton :
Great article Kevin. You've perked my interest in Journalytic. I had never heard of it before but I really like how its calculates the opportunity cost of past decisions, this is really interesting. If you have tried using it, do you have any additional thoughts?