Aswath Damodaran is a professor of finance at the Stern School of Business, New York University. Here is an extract from his blog post - The Search for Investment Serenity: The Look Back Test!
Satchel Paige, the American baseball pitcher, is rumoured to have once said “Don’t look back. Something might be gaining on you” and most of us take his advice to heart, especially when it comes to investments that have gone bad. Investors spend almost all of their time thinking about investments that they can add to their portfolios, we repeatedly check on our "winners", crediting ourselves for our foresight in picking them, and studiously avoid looking at the "losers".
Studies of investor behaviour find substantial evidence that investors hold on to losers too long and that they are quick to blame outside sources or bad luck for these losers, while attributing winners to their stock picking skills.
I believe that the biggest mistakes in investing are made not in what or when you buy, but in what or why you choose not to buy and what and when you sell (what you have already bought).
I know that I need to look at my past investments, not to lament mistakes I have made or to wallow in regret, but because each investment in my portfolio has to meet the same test to remain in my portfolio, as it did when I first bought it. As an intrinsic value investor, that test is a simple one. I should buy when a stock trades at a price below its value and should not if it trades above value.
Consequently, when I look at my portfolio this morning, I should apply the same rule to every investment in it, asking whether at today’s price and today's estimated value, I should buy more of that stock (if it has become even more under valued), hold on to it (it is remains under valued or has become fairly valued) or sell the stock (if it has become over valued).
Simple, right? Yes, if are a serene investor who can be dispassionate about past mistakes and rational in your judgments.
I am anything but serene, when it comes to assessing past investments and I know that what I choose to do will often be guided by the worst of my emotions, rather than good sense. I will double up (or down) on my losing investments, not because they have become more under valued, but because of hubris, will hold on to my losers, because denial is so much easier than admitting to a mistake, and sell because of panic and fear.
While I cannot will myself to rationality, there are things that I try to do to counter my all-too-human emotions.
1) Due Process
Left to my own devices, I know that I will selectively revalue only those investments that I like, and only at the times of my choosing, and ignore revaluations that will deliver bad news. It is for this reason that I force myself to revalue each investment in my portfolio at pre-specified intervals (at least once a year and around significant news stories).
2) Spread my bets
I have found that I am far more likely to both panic and be defensive about investments that are a large portion of my portfolio than for investments that are small, one reason I stay diversified across many stocks (each of which passes my investment test) rather than a few.
3) Be explicit in my valuation judgments
I have found that is far easier to be delusional when you buy and sell based upon secretive, complex and closed processes. It is one reason that I not only try to keep my valuation assumptions explicit but also share my valuations. I know that someone will call me out on my delusions, if I try to tweak them to deliver the results that I want.
4) Admit publicly to being wrong
I have tried to be public about admitting mistakes, when I make them, because I have found that it frees me to clear the slate. I must admit that it does not come easily to me, but each time I do it, I find it a little easier than the last time.
5) Have faith but don't make it doctrine
I have faith (misplaced though it might be) that I can estimate intrinsic value and that the price will eventually converge on the value and that faith is strong enough to withstand both contrary market movements and investor views. At the same time, I know that I have to be willing to modify that faith if the facts consistently contradict it.
I can hope that one day my investment decisions will not be driven by need to defend, deny or flee from past mistakes, but I am still a work in progress in my quest for investment serenity.
