From the November 2013 issue of Research Magazine • Subscribe!

The Mistakes Your Portfolio Needs

Harnessing error is a key to investment success

Everyone makes mistakes. In a world where almost nothing is certain, you can bet the ranch that mistakes will happen. Making them is as normal as breathing. Warren Buffett makes them; so do Tiger Woods, bus drivers, airline pilots and neurosurgeons—anyone who is alive, was alive or will be alive. No one can escape. We are all doomed to err.

I've missed my freeway exit, slept past my stop on the train, left the back door unlocked, run out of gas and made my share of investing mistakes. Each one was embarrassing, some costly, and all of them were uncomfortable, some excruciatingly so. But more than anything else, mistakes laid the pathway of my own growth—and I’m not alone.

Chess and Surgery

Elizabeth Spiegel may be to chess what John Wooden, Red Auerbach and Phil Jackson combined were to basketball. But where Wooden, Auerbach and Jackson achieved their greatness with some of the best basketball talent of all time, Spiegel created her chess juggernaut at a regular run-of-the mill intermediate school in Brooklyn—with a student population drawn from the surrounding lower income, working-class neighborhood.

In local, regional and national tournaments there may be better individual players than those from I.S. 318, but in aggregate—as a team—no school anywhere in the country can come close to matching their regular success at every grade. Year in, year out their level of excellence is so consistent that, if they don’t win a tournament, they are always in the running.

What is her secret? Of course there is the part that can’t be replicated—her unique combination of toughness and respect for her students. But at the end of the day it is her simple, passionate and consistent focus on mistakes. She forces her students to see where they are weak—to look at their errors, evaluate why they are happening and correct them. It is this persistent insistence that they focus on those very things they’d sooner forget that has made I.S. 318 the best chess school in the country bar none—and given her students tools for success that will serve them the rest of their lives.

“I try to teach my students that losing is something you do, not something you are,” says Spiegel (quoted in Paul Tough’s book How Children Succeed).

Five years ago at Beth Israel Deaconess Medical Center in Boston a patient awoke in the recovery room and asked her surgeon why there were bandages on the wrong side of her body. This kind of outcome is everyone’s worst nightmare—and as medical mistakes are now by some estimates the third largest cause of death after heart disease and cancer, it is a nightmare that is happening far too frequently.

As recounted in Kathryn Schultz’s book Being Wrong, the surgeon and the officers of Beth Israel reacted to this situation in a way that can only be termed extraordinary (and unfortunately uncommon): The surgeon explained what happened, how the mistake was made, then apologized sincerely to the patient and promised a path to correct the error (which was done). Within days the hospital sent out an email to all 5,000 employees informing them of what happened. The hospital also issued a press release taking full responsibility and doubling down on existing efforts to reduce medical errors.

Hospital officials even started publishing medical error records online in an effort to be completely transparent. As painful and embarrassing as it was to admit fallibility, they knew that the only way to achieve excellence and reduce errors was to be brutally and publically honest about their screw ups.

Science and Money

We mess up so often it isn’t hard to imagine that mistakes are part of our DNA. This is not just a metaphor. Darwin’s incredible insight of natural selection is the result of genetic mutations. Mistakes in the inheritance of the genetic structure from one generation to the next are what create variation in a species, and it is that variation that allows a species to adapt and survive. We would not even be here to have this discussion if not for a unique series of naturally occurring mistakes.

But there’s more: The entire Scientific Revolution was purposely built on a foundation of error. The basis for every scientific insight is a hypothesis—and every hypothesis must be constructed in such a way that at some point in the future it can be proven wrong. All the growth in our scientific knowledge has been based on the failure of one theory after another. As Kathryn Schultz writes, “Errors do not lead us away from the truth. Instead they edge us incrementally toward it.”

The investment world has benefitted mightily from the insight that being consistently average can lead to a very satisfactory, even outstanding, result. Despite the fact that almost every participant in the stock market is making some kind of mistake in judgment, in expectation, in measurement and observation, the aggregate result of all their mistakes translates into a better outcome than that of most of the individual participants—which is why indexing has become so popular.

Whether or not indexing will survive its own success is another story; my point here is that indexing’s massive success is built on mistakes—millions of them.

Mistakes are the elemental stuff from which is built the foundation of survival and success—whether individual or collective, existential or intellectual. The few examples noted above represent an infinitesimal fraction of the unlimited things we can achieve when we harness the lessons of our mistakes.

Unfortunately, in the investment world the pressure to appear successful all the time is so intense that the very behavior we know will lead to real and lasting success is perversely considered to be a mark of weakness and failure. Within this context, funds that experience disappointing or below par results do their best to finesse or ignore their mistakes—leading to opaque shareholder reports that excel in filling pages with words that have little to no meaning or value. With nothing of any substance being offered to them, investors in these funds are forced into the unenviable position of buy-and-hope with all too predictable results.

But there are fund managers who understand that acknowledging their mistakes and discussing them openly is a sign of strength and intelligence; this enhances their ability to become better investors. Shareholders benefit because when they know that their investment managers are committed to honest and transparent communication; this builds trust, confidence and loyalty. Finding perfection is impossible and only blind luck will lead you to hire a manager who is on the cusp of truly outstanding performance. But if you know what you’re looking for, it isn’t too hard to identify excellent managers who are unafraid to let you know they are actually human.

Wall Street firms have spared no effort or expense to gain advantage using insights drawn from the physical sciences—and in those areas individual investors are at a distinct disadvantage. However those same firms are caught in a web of conflicting incentives that make it next to impossible to exploit the kinds of insights I've discussed above, leaving the individual investor free to access the benefits without limit. Our mistakes are rough diamonds lying at our feet—all we need to do is pick them up and take a moment to appreciate what they could become with a little effort.

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