Said Better Than I Could

I'm impressed with the clarity of thought the folks at "Motley Fool". I could not say this better in the context of self - evaluation and articulation of imaging oneself. No more comments:

My 4 Failures and 1 Major Flaw

Motley Fool CEO Tom Gardner enjoyed a recent article by Fool analyst Scott Hall so much that he wanted to share it with all Fools. Tom called Scott's commentary "as useful as it is eloquent." We hope you'll think so, too.


By Scott Hall (TMFRosetint)

Inclement weather here in Alexandria recently caused Fool HQ to close for the day, so I'm writing this in my apartment at 4 a.m. I keep odd hours. This may not seem particularly relevant, but I've found that reflecting on my life -- while in solitude -- helps me crystalize the lessons I've learned so far.

While I was staring at my ceiling trying (and failing) to go to sleep, my thoughts took a turn toward my own flaws and failures.

Failures in how I've perceived myself and the world around me. The sort of failures that are hard to understand and change because they require looking in the mirror and admitting long-lasting mistakes.

I compiled a list of these failures, mostly relating to mental traps I've caught myself in over the years. They're not all directly related to investing, but to bastardize Charlie Munger's teachings, having a multidisciplinary understanding of just how dumb you really are is probably useful. And in the end, I realized that all these failures stem from just one major flaw in myself.

Failure No. 1: Writing Off Rule Breakers

This one is probably the flaw that has cost me the most monetarily. When I first came to The Motley Fool three years ago, I was a diehard value investor -- a true believer in the writings of Benjamin Graham.

With history as my guide, I was certain that value stocks outperformed growth stocks, and I was pretty sure anyone buying stocks with a P/E ratio of 100 was just asking to go bankrupt.

But being so dismissive of the growth-fueled Rule Breakers investing style was absurd, given that I was working for the company that pioneered it. To make matters worse, I ended up penning an article about Facebook (NASDAQ: FB) when its stock price was hovering around $30 per share.

In it, I pointed out the company's "slowing" growth and sky-high P/E ratio of 106 as reasons some insiders were cashing out, and I used Facebook as a warning to avoid getting suckered in by the "Wall Street hype machine" next time.

Since then, Facebook's stock has risen about 190%, compared with just about 60% for the S&P 500. Whoops. Not only does my article look stupid in hindsight (it was), but I also cost myself a lot of money by writing off the stock so quickly.

What did I do wrong here, aside from being way too sure of myself? I misused historical analysis to try to understand what would happen in the future. Just because high-multiple stocks have been known to underperform in the past doesn't mean that they will continue to do so, and it certainly doesn't mean that any individual high-multiple stock will fare poorly.

For Facebook in particular, I underestimated the power of its network effect, which is perhaps the largest in the history of humanity, and the fact that its business model has essentially no comparison going back more than a decade or so.

Put more simply, Facebook is not the same sort of high-multiple stock your grandparents would have owned. It is a nearly infinitely scalable business that requires relatively minimal capital reinvestment.

Furthermore, Facebook's growth feeds off itself and has created a power-law dynamic, putting it in prime position to be one of the main beneficiaries as ad dollars shift from old media to new. I didn't adequately recognize this and viewed Facebook as just one of many players in the online advertising market.

In reality, it will probably end up being one of a few companies that will split the majority of the pie. When you apply conventional thinking to power-law businesses, they will almost always appear "overvalued." I missed a substantial gain because of this, though I've since purchased shares.

Failure No. 2: Complaining Without Doing

My second failure can be applied to a lot more in life than just investing and is much simpler to understand. It's complaining about what's wrong with something without stepping up and trying to improve that something yourself.

Not only does complaining have a 0% chance of improving the situation, but it's also likely to make other people resent you. Once that seed is planted, it's much harder to work with those people later if you do have suggestions -- because you've given them every reason to question your motives by letting them know what a poor job you think they're doing.

Unless you're willing to put your boots on and test new ideas together, it's probably better to just keep quiet and let other people do what they do best. Otherwise, you're contributing nothing of value. I've learned this one from experience multiple times.

Failure No. 3: Doing Without Understanding

This is tied pretty closely to the previous failure and is probably the most important of the three, as far as improving yourself is concerned. Let's say you've conquered Failure No. 2, have put your boots on, and are ready to parachute in and fix everything you see wrong with the world.

Well, then, you've hit Failure No. 3: doing without understanding. As it turns out, for just about every process in the world, someone at some point decided it was the best way to deal with the problem it addresses.

Why does that matter? Because more likely than not, the dragon you're trying to slay exists for a reason. It probably works decently well, or at least did at one point. Otherwise it wouldn't have been created in the first place.

Before you jump in and try to change the process, you need to understand why the process works as it does in the first place. What's it optimized for? Why was it designed that way? Have any other processes been tested? If so, why aren't those processes the ones that survived?

If you don't take the time to do this, you'll be going in dark -- with no real idea of how to build a new process to your satisfaction while incorporating the attributes that made the old process successful.

Fortunately, although this lesson is very important to understand, it's also simple to understand. To ensure you don't fall into the trap of building a useless process, you need only learn how the existing process works, bottom to top. You must also leave your ego at the door so you can learn from the people who have mastered the existing process. Once you have, you may discover that your attempts at improvement were misguided, or at least will be much harder to successfully implement than you originally thought.

Failure No. 4: Undervaluing Incremental Improvement

This can be applied to investing or process-making. Often, we like to go for the big score; a company that will become a 100-bagger or creating a process that completely changes how something gets done.

Those things can be wonderful, but they're rare and not essential to success. Suppose the market returns 10% per year for 50 years, while you manage to earn 11% per year. That doesn't sound like a big difference on a yearly basis, but it adds up over time.

Starting with just a $10,000 investment, you'd have roughly $1,173,908 after 50 years by getting the 10% return. But if you got the 11% return (although it doesn't seem like much of a difference) you'd have $1,845,648 instead -- almost $700,000 more.

The same thing can be applied to churn rates for subscription businesses such as Netflix(NASDAQ: NFLX). Although a few percentage points of difference might not seem like much, over time, they can compound out to be an enormous difference.

For example, if you have 1 million subscribers and 98% of them renew their contracts annually, you'd have about 817,073 at the end of 10 years. But if only 95% renew annually, you'd only have about 598,737 left after 10 years.

The percentage-point change in renewal is very small, but it makes a huge difference in the value of those customers over time. It goes to show that you really should sweat the small stuff.

I underestimated the implications of this for a long time before I joined the Fool and would often try to hit home runs with my investments, concentrating pretty heavily in these ideas. It worked out modestly favorably on average, but it was tax-inefficient, required a lot of effort, and was very risky.

These days, I buy two or three companies a year and just hold them. It saves a lot of time and energy, and assuming I can earn just a few points of market outperformance, will add up to a material amount over time.

The Common Theme

You're probably wondering by now what all of these things have to do with one another. The answer is hubris.

The idea that I knew so much about Facebook that I was certain it was a bad investment. That I knew more about whatever I was complaining about that day than people who'd dedicated their lives to it. That I should try to hit home run after home run with a concentrated portfolio, despite the risk of a massive drawdown.

All of these failures ultimately tie back to my own ego. I was far too confident about too many things. I've become better about this over the past year-and-a-half, but my ego's still there.

It's not even entirely bad, as long as it's managed -- you have to have some level of ego to try your hand in any new field.

The key, I think, is not to stop trying to improve things: it's to try to improve things while understanding that you probably know nothing about what you're trying to improve.

Act according to your inexperience, gain understanding, and then create your plan of action. Otherwise, you're just tilting at windmills.

Scott Hall owns shares of Facebook. David Gardner owns shares of Facebook and Netflix. Tom Gardner owns shares of Facebook. The Motley Fool owns shares of Facebook and Netflix.

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