Wednesday, May 2, 2012

Learning From A Random Outcome

Humans have the ability to learn from their mistakes. In so doing, they can reduce the likelihood of repeating such mistakes, which should theoretically lead to a better existence. Therefore, it should come as no surprise that investors wishing to improve their investing acumen will attempt post-mortems on their investment decisions in order to determine what went right and what went wrong. But as I attempted such a post-mortem on a risky investment that didn't pay off, a commenter made an interesting point:

"I think one has to be *very* careful about learning lessons from random outcomes...investing is an inherently probabilistic activity...there's a huge impact from the unpredictable and unknowable."

The commenter then went on to point out another risky investment that this time did pay off, and made the point that the outcomes of these two cases could have easily been the reverse (i.e. the first stock could have paid off while the second stock failed), based on the information that was public at the time.

I think the commenter makes a valid point to a certain extent. The problem with such post-mortems is that even though things turned out a certain way, we cannot know whether this was the result of an unobserved or unobservable phenomenon which skewed the results a certain way. Maybe the reasons for the investment were poor, for example, but the investment still worked out because market prices rose as a result of unforeseen economic events. In this case, the investor would learn a false lesson that may not help or may even hurt his attempt to become a better investor.

However, this does not mean studying past investments is useless! If done on a large scale, I would argue that it's the best way to learn how to invest, as it utilizes one of the best forms of learning there is: the case method.

Statistical research demonstrating the effect of one or two factors (e.g. the effect of low P/E and/or management ownership on future returns) at a time can be useful, but only by studying many cases where an infinite number of these factors interact with each other can the investor develop his skills at the art of investing.

By studying only a handful of cases, the investor could be led down the wrong path due to the effects of randomness. However, the investor need not limit himself to only the handful of cases he has himself experienced. The works of numerous value investors are published and available to all. Investors who take advantage of the many thousands of cases that are out there gain the experiences of seasoned investor veterans.

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