6 Billion Errors Per Day, Minimum

A few weeks ago, I mentioned we were 50% long, 50% cash (up from 100% cash in May), 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 and 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.

Investors are just as wrong just as often, including errors on the really big things: An assumption we made about a major issue, a small but crucial fact we misremember, a forecast we made 6 months ago — just some of many things we believed that were all wrong. Consensus for earnings, econokkmic reports, how the markets behave. Expectations are rarely made, consensus is frequently off. We are habitually, regularly, predictably wrong about nearly everything.

Rather than fight our foibles, people should admit to themselves that this error stream is real. Why not repair the errors of our ways as soon as we discover them?

I have noticed over the years the difficulty some investors have in cutting losses, admitting an error, and moving on. Way back in 2005, I wrote a piece advising people that they should Expect to Be Wrong (originally published 04/05/05). In it, I noted that “I am rather frequently — and on occasion, quite spectacularly — wrong.” However, if we expect to be wrong, then there should be little or no ego tied up in admitting the error, honoring the stop loss, then selling out the loser — and preserving capital.

Which brings us back to the hubris of the aforementioned fund manager. I see three error related problems he is suffering from:

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 cannot 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 them . . .

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

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Previously:
2009 Investing Mea Culpas (January 7th, 2010)

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

The Zen of Trading (June 1, 2005)