By Justin Carbonneau (Twitter | LinkedIn | YouTube) —
Netflix has a new documentary out (Unknown: Cosmic Time Machine) on the development and launch of the James Webb Telescope (JWST). The documentary highlights how much time, effort and ingenuity went into the telescope’s development and ultimate successful launch into space. One thing that jumped out at me as I was watching it – the launch and deployment had 344 identifiable failure points, with 80% of them at risk during the launch phase. NASA and outside engineers on the project worked diligently addressing these, having redundancy plans in place in the event of a malfunction or some other exogenous event.
This idea of multiple failure points, and what NASA did to prepare for them, brought me back to a conversation we had with Jim O’Shaughnessy, founder of O’Shaughnessy Asset Management, about passive vs. active investing (go here to watch). In summary, Jim was making the point that most passive investors have one big possible failure point, which is selling after a big decline in stocks (this usually detracts from returns), while those investors in active strategies also run that risk there, but there is an additional risk in that the actual active strategy you have selected will likely deviate from the market. And when good active strategies underperform, many investors are likely to capitulate and move on from the strategy, thus the second point of failure.
If as investors, we are aware of these possible points of failure upfront, just like NASA and the engineers behind the JWST were, maybe we can better prepare to make sure we give ourselves the best chance for success. Warren Buffett and Charlie Munger have consistently talked about how avoiding big mistakes is key and keeps them in the game long-term.
Here are a few other investing failure points and actions you can consider.
Setting Unrealistic Expectations
Investors often set unrealistic expectations, hoping for extraordinary returns in a short period of time. This behavior can lead to disappointment and frustration when these expectations are not met. Instead, adopting a realistic outlook and focusing on long-term goals can lead to more rational investment decisions. With the JWST, failure was not an option but I think all the engineers knew there was a chance of something going wrong. Set the right, realistic expectations going in and it can produce better long-term outcomes.
Being Overconfident
Overconfidence can cloud an investor’s judgment, leading to impulsive actions and excessive risk-taking. Acknowledging the limits of one’s knowledge and remaining humble can help avoid potential pitfalls caused by unwarranted confidence. Morgan Stanley’s Michael Mauboussin and Dan Callahan recently published Birth, Death, and Wealth Creation, which was a study on the success and failure in publicly traded U.S. stocks. The report highlighted research from Hendrik Bessembinder, a Professor of Finance at Arizona State University, which shows a vast majority of the long-term wealth creation comes from a small percentage of stocks (i.e. Apple, Amazon, Exxon, Berkshire Hathaway and others, see below). If you’re a long-term holder of stocks like these, that is great, and I personally know people who have generated massive wealth by investing in some of these names. But, that can be more luck than skill and it’s important to not let a serendipitous stock pick go too far to your head.
Forgetting About Downside Risk
The engineers on the JWST were consistently thinking about failure, testing all different scenarios, conditions and possible mishaps that could put the mission at risk. Great investors like Warren Buffett understand that risk is always present and the key is being able to stay in the game over the long-term and not get “blown up” (my words, not his). Just like overconfidence, a long bull market can blind many investors to the reality that stocks don’t always go up and 10% corrections are common, 20% bear markets happen once or twice a decade and stocks can even fall in some cases by 50% or more.
Lacking Diversification
When the JWST engineers identified a failure point, they added in redundancies and back-up plans to ensure they had multiple ways to address these mission-ending mistakes. The bottom line: they were as diversified as possible in their approach to avoiding these possible failure points.
Just as the JWST engineers took a diversified approach to avoid mission-ending mistakes, diversification is a fundamental principle in the world of investing. Spreading your investment across different assets and asset classes, rather than putting all your money into a single investment or being overly concentrated in a specific area of the market is essential. By diversifying, you are less reliant on the success of any one investment, just as the JWST engineers build diversification into the troubleshooting approach.
Knowing When Failure Is Likely to Occur (and understanding it is ever-present)
With the JWTS, 80% of the failures were during the launch phase. For investors, bear markets are similar to the launch phase because that is where I believe the majority of investors make mistakes. Since investors feel losses psychologically more than gains, bear markets result in fear as investors extrapolate losses out into the future and make poor timing decisions with their investments that in most cases detract from long-term returns.
But as the documentary pointed out, there are 49 failure points that never go away. As the JWST peers deep into the origins of the universe and sends back images from galaxies from billions of years ago, there still remain known and unknown risks. Those are risks that can’t be avoided. It’s the same thing in the markets, we can talk about recessions, bear markets and bad timing decisions, but it’s important to understand these risks are always present but realizing that to be rewarded in the markets, you have to bear these risks. Understanding and accepting that is important step to getting the most out of your investments over time.
One of my favorite movie scenes, from Interstellar – when failure was not an option!
