Why Regret and Good Investing Don’t Mix
Last year, during the Q&A portion of one of our quarterly investment webinars, we were asked if we regretted selling pet insurance company, Trupanion in the summer of 2019 since the stock had gone on to outperform the market after we sold.
It’s a great question that applies to circumstances beyond Trupanion, so it is worth addressing at greater length.
We feel regret because we believe a decision we made (failure of commission) or didn’t make (failure of omission) produced a worse outcome than should have happened.
Regret has evolutionary purposes as a learning tool – “I really shouldn’t have thrown rocks at the hornet’s nest. I won’t do that again.” It is ingrained in our psyche for a good reason. Even so, regret doesn’t mix with good investing.
Morgan Housel once interviewed the legendary behavioral psychologist Daniel Kahneman for The Motley Fool, and Kahneman said something about regret that stuck with me.
“[Regret] is the killer. You’re losing, and then you decide, ‘Oh, it was all wrong. Let me stop,’ and that’s when disaster strikes, I think. It’s changing course…
You have to inoculate yourself against regret. You have to be prepared for things to go bad.”
It’s worth repeating. In investing, you have to inoculate yourself against regret.
Boy, that’s hard to do. None of us want to look or feel foolish for decisions we make or don’t make, and no one likes losing money. But unless we’re prepared for an adverse outcome and make peace with it, we stand no chance of achieving our goal of outperforming the market over the long term.
This doesn’t mean we shouldn’t care about our outcomes – of course we care! So how do we minimize regret as investors?
It starts with a well-designed investment process and careful consideration of qualitative and quantitative factors that inform our decisions.
Because of our team’s faith in our process, we can confidently say: “With perfect hindsight, would we have benefitted from holding Trupanion rather than selling? Absolutely. Do we regret our decision? No.”
Knowing what we knew then, we would have done the same thing.
That may seem like an odd conclusion, that we are avoiding responsibility for the poor outcome. But as investors, we don’t have the luxury of hindsight when making decisions. Instead, we must make forward-looking decisions based on our present analysis. No matter how thorough the process is, any decision we make will never have a 100% probability of proving correct.
Luck – good and bad – always plays a role in outcomes, which is something we can’t control.
In Michael Mauboussin’s book More Than You Know, he writes:
“Results – the bottom line – are what ultimately matter. And results are typically easier to assess and more objective than evaluating process.
But investors often make the critical mistake of assuming that good outcomes are the result of a good process and that bad outcomes imply a bad process. In contrast, the best long-term performers in any probabilistic field…all emphasize process over outcome.” (emphasis mine)
In a probabilistic field like investing, the focus should be on optimizing process rather than allowing outcomes to swing your emotions.
What’s more – and this is important – if we’re doing our job well and identifying great businesses in our portfolio, the odds are higher than average that a stock we sell will subsequently generate impressive returns. As such, we must be able to watch a stock we sold do well, knowing that it no longer fits our ownership criteria for one reason or another.
Conversely, if Trupanion flopped after we sold, it might have made us look “smart” to outside observers, but internally we would have questioned our process for including it in the first place.
And that’s what’s critical to us – we want to see our process identifying exceptional businesses that trade at attractive valuations. Over time and across many decisions, our process has produced strong results and we believe that this will continue.
Owning just 20 to 30 companies that we think are in the top-tier in terms of quality, we must be selective about what we include and keep. If we sell a company in our portfolio for reasons other than valuation, it most likely slipped below our threshold on conviction. This does not mean the sold company has suddenly become a terrible company.
Because of our confidence in our process, we don’t spend much time considering companies we’ve sold. If we do, it’s because the decision revealed something lacking in our process and the need for improvement.
We’ve written, for example, about learning from our mistake of selling Costco in 2012. As our process improved in the subsequent years, we more fully appreciated Costco’s business and eventually added it back to the portfolio. Costco’s stock performance in the interim bothered us far less than the shortcoming it exposed in our process, but it led to improvements, hopefully leading to better long-term outcomes.
In contrast, we have not given any thought to exiting Apple a few years ago despite its continued success. Years back, we wrote extensively about Apple, and Sean and Arif were both sought out by major media outlets for their opinions. Compared with our Costco decision in 2012, we feel we thoroughly understood Apple’s business. At some point, however, it no longer fit our process.
Investing is a decision-making business. Letting outcome-driven regret seep into your process grinds the machine to a halt, rendering it useless or destructive to value creation. At Ensemble, we’ll continue prioritizing process over outcome and think that’s the healthiest approach investors can take. In the end, results are what matters. But to reach the intended results, you must follow a process that works. That’s what we’ve done over the last nearly 20 years and its what we intend to do over the next 20 years.