Learning from Investment Errors: Crucial Insights for Smarter Decision-Making

There is an old saying, “Fools learn from their own mistakes, but the wise learn from the mistakes of fools.” We all aspire to be wise and learn from the mistakes of others. The investment journey could be so much more pleasant and profitable if we could only avoid making mistakes.

However, making mistakes is a critical part of the learning process. As John Maxwell says in his book, “Sometimes we win, and sometimes we learn,” life is all about learning from our mistakes or experiences. This article aims to discuss some of the biggest mistakes investors make and the lessons learned from them.

Mistake #1: Poor Diversification

Many great theories on portfolio composition exist. Here is an example of a really simple approach: invest in 8-10 well-diversified, non-correlated asset classes. This could substantially reduce portfolio risk while maintaining overall return targets. It requires skill and understanding to truly build a portfolio with lower risk, but a strong return profile.

This is a wonderful strategy, but the biggest error that investors make with any well-diversified strategy is that they forget to rebalance when some investments go up and others come down. Over time, some investments grow in value and some fall, and the weight of some parts of the portfolio becomes too heavy. Prudent rebalancing is the key.

Psychologically, it is difficult to sell the winners and to double-down on the losers, so to speak. It is important to understand the fundamentals of each investment and consider what appears to be overpriced and what is undervalued. Ultimately, it is all about the risk/reward ratio that each investment offers. Disciplined portfolio management is required to avoid emotional attachment to certain “favored investments.”

Mistake #2: Forgetting that “Past Results Don’t Guarantee Future Performance”

We are all at risk of becoming too complacent when times are good, when investments are performing well, and when the “incoming tide is raising all boats.” It is only human to rejoice and celebrate successes.

Most Nobel Prize winners don’t accomplish anything significant after winning that recognition. Most athletes who appear on the cover of Sports Illustrated see their averages drop afterward. The reason for these observations is very simple: it is very difficult to maintain world-leading research or achieve athletic world-leading performance in general. The same can be said about the world of investing. There are some companies that continue to innovate and lead for long periods of time, but these are unicorns.

There is an expression that states, “All good things must come to an end.” This just reflects that nothing in life is permanent, and sooner or later, the good times end. And the same can be said about difficult times. The world somehow statistically “reverts to the mean.”

In general, we would like to double down on what works, and cut our losses. However, this strategy can be at risk of the trend or pattern breaking and reversing direction. “The trend is your friend until it is not.”

Mistake #3: Investing in “Bright and Shiny” Objects

It is too easy to be attracted to things that look “pretty” on the surface, especially if expert marketers deliver a well-prepared presentation. In the world of private and even public investments, there are many very skillful promoters, “brilliant marketers,” “snake oil salesmen,” and even master con artists. These “shady characters” often prey on innocent investors who lack the ability or desire to do proper due diligence before making an investment decision.

Some of these people even promote the idea of strong due diligence practices. They know how to disguise their inferior offering or a high-risk strategy as a “bright and shiny” opportunity.

There are no shortcuts here; the only solution for prudent investors is to learn how to do proper due diligence work, including but not limited to:

– Due Diligence on the principals/people
– Due Diligence on the asset/project/strategy
– Understanding the true risk vs. reward of the investment
– How the opportunity fits into the portfolio goals, timeline, and other requirements

Please remember that for every good investment opportunity, strategy, sponsor, developer, fund manager, there are likely 10+ mediocre or bad ones.

One must learn how to say “No” to a wide majority of things out there and very carefully pick the few investments that make the most sense, and of course, make sure that they always maintain prudent diversification at all times.

Mistake #4: Ignoring or Not Respecting Market Cycles

Understanding market cycles is not easy. We often don’t know if we are approaching a peak of the cycle or are near a bottom. Peaks and bottoms are often only visible in the rearview mirror. But there are leading indicators that can help investors understand that we might be approaching a change in the trend or a significant shift. Gradually changing market conditions may be recognized over time, giving investors an opportunity to make appropriate investment decisions.

However, there are times when “black swan” events disrupt the world order or create a fast-changing environment. COVID-19 was one of these occurrences that massively disrupted our way of life, broke normal market trends and cycles, and caused global inflation as most governments decided to print money to avoid a massive economic recession with the broad closures and shutdowns. As a result, many central banks responded by rapidly hiking interest rates, thereby massively impacting those investments that are sensitive to interest rate fluctuations.

Certain asset classes experience very high volatility in response to disruptions in supply and demand conditions. For example, oil prices collapsed right after the start of the pandemic with the world shutdowns but recovered quickly when the world re-opened.

Some market cycles are long and gradual, and some are short and volatile.

Mistake #5: Investing Without a Good Understanding of the Risk/Reward Profile of the Given Opportunity

Many investors have a good idea of what they want to generate in target return, e.g., 10% per year passive income. So, they look for the investments that project target returns of say 10-12% per year in whatever the strategy offered by the promoter. There are many promoters that build their marketing materials and offering documents in a manner that targets that return profile because they know that there are many investors looking for that return target figures. It’s a very clever marketing ploy to match the “offerings” to the desired outcomes by the investors.

There are absolutely legit strategies and offerings by reputable fund managers and operators that provide returns in that target range with “institutional quality” terms, well mitigated risk via the prudently diversified portfolios. For example, let’s take conservatively focused Real Estate Income funds. The underlying asset portfolio and offered investor terms represent truly likely “risk-adjusted” outcomes in the 10-12% target range. I will use a classic example of say, 7-8% Preferred return structure, 2% asset management fee, and say 70/30 (Investors/Manager) split within a fund. Let us say that fund asset model seeks to generate 14% annually, risk-adjusted ROI. Following these fund terms, investors expect to receive say 10-11% net annual ROI and the fund manager to make 3-4% compensation for their work. This structure ensures a fair distribution of risk/rewards and should get investors their target returns on average over time.

There are also offerings out there that “target” 10-12% projected returns to meet the demand, but the terms of the investment are horrific to investors and highly beneficial to the promoter, or developer, or manager. Many investors get attracted by the “bright and shiny” objects and the very sleek marketing presentation and documentation that make them feel safe and secure. Investors are often presented misleading information, or projections based on assumptions that are difficult to meet, or are given a track record that was during a strong market, or other information that “puts lipstick on a pig”. However, the underlying investments struggle to generate target returns because they were sold at an inflated price to investors without their knowledge or understanding that the sponsor made a large upfront profit and there is little alignment of interest between the investor and the promoter.

There are only very few investors who ask the question to the promoter, sponsor, manager: “How are you making money?” Or “Can you explain all the fees and profits that you are making on the investment?”

Why does this matter?

Because you as an investor want to always understand and verify that there is strong alignment of interest between the investment sponsor, manager, promoter, developer and you. Furthermore, you want to understand how much risk are you taking and what reward are you going to receive vs. how much risk/reward will the promoter/manager receive if the investment succeeds and also understand if the promoter is getting paid massive fees or profits upfront. Also, what happens if the investment underperforms the projects, or worse what happens if the investment fails.

Every investment has risks, and this is something that all investors must understand and accept. There might be great deals and excellent fund managers, developers and operators that fail in certain difficult circumstances or market conditions. And conversely, there might be terrible offerings and bad promoters that will make you good returns in strong or lucky market situations.

However, luck eventually runs out and mathematical laws of averages kick in. Investments with great managers and fair investment terms should significantly outperform on the risk-adjusted basis vs. the investments that are heavily promoted, but have inferior terms.

In conclusion, the old saying “live and learn” teaches us the wisdom of continuous learning. The investment journey is full of mistakes and errors. Smart investors learn from their mistakes as well as the mistakes of others, and get better at portfolio diversification and rebalancing, understand that we can learn from the past, but the future may be very different. Furthermore, they

 learn to stay away from the heavily promoted “bright and shiny” objects, and become good at doing proper due diligence work truly assessing risk vs. reward of every opportunity and invest with people who align their interests and compensation with the results of the endeavor. Finally, the best investors learn how to recognize and respect market cycles and make appropriate investment decisions.

I hope this short discussion was helpful. I am a perpetual student and a scholar and seek to improve my investment skills every day. Sometimes, the investment journey is a roller-coaster ride and sometimes it is “smooth sailing”. Enjoy the investment journey and get better at it every day.