The Danger of Learning From Your Mistakes

By Jack Forehand, CFA

One of the major changes I have made in my life in the past few years is that I have significantly increased my focus on learning. In the past, I tended to focus too much on the things I knew, while not focusing enough on the things I didn’t. That changed for me when I realized that no matter how much I know, the number of things I don’t know will always far outnumber those that I do.  

One of the side effects of paying more attention to learning has been a renewed focus on my own mistakes. Most of the best lessons I have learned in my life, and in my investing career, haven’t come from a textbook. They have come from the process of doing things in the real world, and learning from them when I don’t achieve the desired result. As time has gone by, I have learned that trying things and failing often leads to a significantly better outcome than not trying them at all.

But there is a downside to learning from your mistakes.

The process of learning from things you do wrong requires that you learn the right lessons and don’t draw the wrong conclusions from your failures. And sometimes that is easier said than done.

Here are some things I have learned that have helped me prevent lessons from my past mistakes from turning into new ones.  

Taking a Lesson Too Far

I worked for a company that was the precursor to Validea that existed during the late 90s tech bubble. I started as an intern with the company at that time and ended up being the 6th full time employee of the firm once I graduated college.

As was the case with most Internet companies back then, my job offer included very little fixed compensation. It was primarily based around equity.

I can still remember the excitement of being given 1% ownership of the company. I recall immediately putting together a spreadsheet of what that 1% would be worth at various future valuations of the company, which I assumed could only rise into the hundreds of millions of dollars based on what other firms were being valued at. When we grew the company to fifty employees and got venture capital funding, those expectations only grew. The problem, of course, is they weren’t grounded in reality.

We had very little revenue and no foreseeable path to short-term profits. All of that value was based on potential. And like most internet companies of that period, that potential was never realized. Eventually, the company was shut down and the remaining venture capital money was returned.

I learned some great lessons from that experience. I learned that profitability matters. I learned that revenue matters (it may seem crazy that this is a lesson I had to learn, but those who went through this period will understand). I also learned about all the behavioral problems we have as human beings that are exposed during bubbles.

Those lessons all became completely ingrained in me following that experience. And they have played a big role in everything I have done since then. They have made me very conservative in how I think businesses should be run. They have made me only want to add expenses when they are absolutely necessary. That has been very valuable during periods like 2008, and helped us make it through then when many firms in the same space as us did not.

But this lesson has also had a significant downside. Sometimes you need to spend money to grow. Sometimes you have to take chances that will cost you if they don’t work out.

Striking the balance between when to be conservative and when to be aggressive is very difficult, but far too often I have errored on the conservative side. And that has certainly hurt our growth at times. Over time, I have learned that even the best lessons can turn into a negative if they are taken too far.

Learning the Right Lesson at the Wrong Time

The bear market of 2008 was a very difficult experience for many investors. We all can prepare for bear markets mentally, but it is impossible to simulate what major drawdowns are like until you actually experience it. For many investors, bear markets expose the fact that the risk of investing in the stock market is too much for them.  

On the surface, learning your limits as an investor can be a very good thing. It allows you to build a portfolio that is likely to stay within those tolerances, and it can help eliminate the behavioral errors that can plague all of us. But even good lessons can be a problem if they are learned at the wrong time.

Many of the investors who learned that their portfolio was too risky learned that lesson in the middle of the bear market. If that lesson led them to take action, it resulted in reducing exposure to equities in the period from late 2008 to March of 2009. That was obviously a terrible time to do that, considering the S&P bottomed at 666 and hasn’t looked backed since. These investors learned the right lesson, but they learned it at the wrong time.

The current extended period of underperformance for value stocks is another good example of this. The magnitude and duration of this period has led many investors to conclude that value investing just isn’t right for them. But if history is any guide (and some argue it won’t be this time), abandoning a value strategy now is likely to be a mistake.

Over time, I’ve learned that when you learn lessons can sometimes be more important than the lessons themselves.

Focusing on Outcome Instead of Process

In a world where luck didn’t exist, judging decisions purely based on their outcomes is a great strategy. Chess is a good example of this. If you lose at chess, you lost because the other player was better than you.

Investing doesn’t work that way, though. Over both short and long periods of time, luck can play a significant role in investing outcomes. The investors who are buying bankrupt companies right now might be thinking that they are superior investors to those who are buying high quality companies. And based on results, they have been right. But I don’t think too many people who have studied history would agree that is likely to continue. Even over decade long periods, luck can still play a major role. Every major investing factor has had 10+ year periods where it hasn’t worked.

As a result of the significant role luck can play in investing, learning from your mistakes can be a tricky process because it requires analyzing the decision-making process rather than the end result. Drawing conclusions from a poor outcome can lead to very bad decisions if that outcome was driven by a good process and was the result of luck rather than skill.

The Double-Edged Sword of Learning from Mistakes

In the end, having a renewed focus on learning from my mistakes has been a very valuable process for me. It has yielded far more positives than negatives in both investing and in life in general. But like anything, there is a danger of taking it too far. I have learned the process of learning from mistakes is a delicate one. It can lead to even more mistakes if it isn’t performed properly.  

Photo: Copyright: 123rf.com / urfingus



Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.