How to Deal With Losses as a Money Manager

This is a weird stock market right now. It is very narrow, where only a few areas are working. But the market is never easy. As Charlie Munger says "only fools think it's easy." From personal experience I can tell you the moment you think it's easy is the moment you are about to get punched in the face.

Rich and Miserable

If you talk to anyone 60+ who actually manages money for living (not a financial advisor who allocates to mutual fund managers, but an actual money manager) I would say there is a 90% likelihood they are constantly grumpy, cynical, and fairly miserable despite usually being very rich. (This is where my wife looks up from reading and says "so remind me again why you decided to go into this business?") While I don't have any scientific evidence of this, I do have vast anecdotal experience with these individuals. 

If the money manager is so rich, why is he so miserable?

The reason is a simple one: He is constantly wrong.

A couple years ago, the fund I was working on was up somewhere around 36% in one year, beating the market, trouncing other money managers, and making all of our clients a boatload of money. The firm was incredibly profitable that year and every principal / employee had the biggest pay day of his life.

Despite that, none of us could help feeling miserable because even though we got many things right that year, we also got an incredible amount of things wrong. Instead of feeling victorious we had self-doubt. Instead of feeling pride we felt shame we didn't do better. Instead of being grateful, we were angry.

You sit there and tell yourself "I can't believe I sold ABC company! It's up 50% from where I sold it! Why the hell didn't I sell XYZ company when I had the chance? I mean I sold some of it, but why didn't I sell all of it? Heck why didn't I go short? I knew it was overvalued! Why didn't I buy more of LMN company, I knew it was going up!"

Did we all need perspective and maybe some therapy? Probably. But that kind of negative demeanor is not unique in this industry. It's pervasive.

It's easy for those on the outside to chaulk it up to greed. "You Wall Street guys are all a bunch of avaricious money lovers!" And while there is definitely a lot of greed on Wall Street, there is an even more powerful emotion: FEAR

Fear of what's caused by being wrong. Because being wrong not only can cause you to lose money. It can also cause you to lose your job. Lose your clients. Lose your friends. Lose your self-esteem, your confidence, your self-worth. Your entire life can fall apart when you are wrong. This is why being wrong causes so much more grief than the celebration that comes from being right. And even when you are doing well, you are still usually wrong at least 40% of the time.

Being Wrong for Reasons Out of Your Control

To summarize so far:

The hard part about managing money: You are frequently wrong.

To take it one layer deeper:

The hardest part about managing money: You are frequently wrong and it is not because of any error in judgement, analysis, work ethic or any single thing that is inside the realm of what you can control.

You are wrong because an earthquake happened out of the blue which caused a tsunami which almost resulted in a nuclear explosion causing all governments across the globe to reconsider their use of nuclear power and many to shut down their plants resulting in a significant drop off in the demand for uranium causing the uranium miners to cut back on drilling, reducing the demand for drilling equipment and then the little drilling equipment manufacturer you own sees its stock price get cut in half. 

This didn't happen to me, it is only an example. But I think it is a good example because there is nothing you could have done no matter how much research you did that would have predicted that your Canadian equipment manufacturer was going to go down 50% because of an earthquake in Asia.

This type of thing happens every day in the money management business.

Separating Process and Outcomes

When it comes to investing, you can be right and you can be wrong (i.e. make money / lose money). But sometimes you are right for the right reasons, and sometimes you are right for the wrong reasons. Sometimes you just get lucky (although it's rare for anyone to admit that making money was anything other than their fantastic skill and brilliance). And sometimes you lose money despite getting everything right in the analysis. The reason is because much of what happens in the market is outside of any individual's control. Stocks may go down because some large fund had an investor pull their money and now they have to liquidate and sell everything. This wasn't caused by any change in fundamentals in the portfolio companies and it is likely that no level of due diligence would have shed light on this development ahead of time.

Therefore, to deal with being wrong, one has to separate the investment process from the investment outcome and analyze each individually.

There are good processes that sometimes lead to negative outcomes, and bad processes that sometimes lead to positive outcomes. While this can happen in other industries, it is not as prevalent in any other career path I can think of the way it is in money management. In most jobs, a good process leads to a positive outcome and a bad process to negative outcomes.

While no good process in money management can always lead to positive outcomes (people have been seeking that kind of Truth for centuries and haven't found it), the aim is to have a process that improves your batting average. If you can get 55% of your investments right, you likely will do very well over time.

Focus on Process

So anytime you are feeling down because you lost money, revisit the process you went through to make that investment. What did you miss that you could incorporate into your process the next time you are conducting your due diligence? What process do you have in place for updating your investment process??? Do you have a way to ensure you are incorporating past mistakes into future decisions? This is where the idea of an investment checklist (I believe first mass-publicized by famed investor Mohnish Pabrai) can come in very handy. Every time you get burned, see if there is a way to add something valuable to your checklist to improve your odds of success the next time around. 

Summary: 5 Step Process for Dealing with Investment Losses

1. Accept that the outcome was bad and that the outcome is fully separate from you and your self worth and skill as an investor
2. Review your portfolio in detail and evaluate your "hit rate" (success rate). Did you lose because of a high percentage of negative outcomes or because of position sizing? You can be right 90% of the time and still lose if all your winners are small percentages of your portfolio and your losers are large percentages.
3. Evaluate your losers and the process that went into making each investment. Besides simply "staying away," what would you have done differently during the process if you could do it all over again?
4. If the process was good but it was a bad outcome, give yourself a break. If the process was incomplete, add those new discoveries to your investment checklist or create another formal way to incorporate them into the investment process going forward
5. Use the updated and revised investment process on new investments going forward and conduct this kind of evaluation on your past investments on a continual basis to always be improving your process.

Remember, focus on the process not the outcomes. Outcomes can be negative regardless of how good your process is for extended periods of time, so have patience. A good process will eventually lead to enough positive outcomes to do very well in the stock market.