The Investor's Fatal Flaw

A mistake can be a beautiful thing, as long as it only happens once. Learning from our failures is one of life’s most valuable exercises, but why are so many of us – myself included – reluctant to admit when we’ve made a mistake? I suspect that the desire to keep our egos intact may play a roll. Of course, this can apply to all facets of life, but in no arena is it more measurable than in finance. One of the great things about money is that it is easy to count. Unlike a long-term relationship, losses in a financial investment are exact and do not require us to reflect on our feelings.

Small losses in financial investments can easily morph into large ones, and the math required to make an investment whole can be counterintuitive and sometimes daunting. For example: a loss of 20% requires a 25% return to break even. The deeper the hole, the harder it is to dig out of. An 80% decline would need a 400% gain to get back to par. Compounding the problem by adding to the position can make matters worse. If you felt a stock at $100 was a good value, odds are you feel even better about it at $90, but at what point do you stop feeling good about it?

Besides ego, another reason people have trouble cutting their losses is emotional attachment. One of my favorite examples of this is the story of Mark Twain. Any high schooler can reference The Adventures of Tom Sayer, but not everyone is familiar with Twain’s abysmal investing record. Twain lost millions of dollars in gold mines and stocks, but his worst investment decision came from a contraption called the Paige Compositor. This invention was supposed to make advancements in typesetting or typewriting. Being an author and writer, Twain was not only deeply financially invested in the cumbersome device but poured a lot of emotion into it as well. Later in his life Twain remarked about his connection to the Paige Compositor as if it were a person.

Mark Twain’s story can show us that it can be difficult to cut your losses. Imagine pouring everything you have, financially, mentally and emotionally into an investment and admitting defeat. We see this time and time again with entrepreneurs and small businesses. In those situations, you almost have to invest your emotion, but adding sentimental value to a mutual fund or a stock is extremely dangerous. When it comes to retirement savings, it is paramount to remember that emotion is the foe of the long term investor.