This is a tale of two unnamed businesses. These are two very popular stocks. Both are strong players in a very hot sector right now. One business sees gross margin growth, while the other business sees gross margin decline over 10 years.
The business with the declining gross margin delivered a 5% CAGR (compound annual growth rate) versus the other one that delivered a whopping 58% CAGR over that 10-year period. A decade ago, one could have bought both businesses. One could have also picked one of them or none of them as potential winners. However, with the knowledge of what has happened, it paints a very different picture. What either of these decisions makes us feel has very little to do with our actual choice.
“Oh, that could have been me.”
How many times have we thought like this? When we miss a winning stock, we are filled with pain. When we miss a losing stock, we are full of joy. This is one of the most dangerous ways to think. A sure way to lead a life full of regret or a false sense of superiority.
We never know for sure
Investing is probabilistic. It means that there is never a 100% guarantee of something happening. Some things will not happen as planned. Imagine that we have a portfolio, can we expect over the next year our portfolio will show a profit?
We can always expect, but at the beginning, we will not know for sure about the actual outcome. The easiest assumption will be that there is a 50% chance of profit and a 50% chance of a loss. At this time, we are not even thinking about current market valuation, asset allocation, interest rate cycle, expected earnings growth, or other external factors.
After one year, we will know for sure if we had a profit or a loss. If we are planning an expense at the end of this year, knowing that answer in advance becomes very important.
Imagine how complex this process feels when we are investing for a much longer-term goal. Like retirement or a planned large expense after 10 or 20 years.
What will be certain in this portfolio?
In this portfolio some outcomes are predictable.
We are bound to miss a few big winners.
We are bound to own a few big losers.
We are bound to own a few big winners.
We are bound to miss a few big losers.
We will have an emotional reaction.
There is also a certainty that we will regret missing the big winners. We will also feel relief for missing the big losers. We will feel like a genius for picking the big winners and we will feel like an idiot for picking the big losers. This is our hindsight talking. Just like the stocks mentioned in the example above could have made you feel good or bad after 10 years. We have very little control over the outcome.
Probability is hard to understand
This is why probability is so hard to understand. We tend to get caught up in loops of joy and regret. We only feel regret when we know we have acted without any planning. Investment outcome will anyway be unknown. If we have some plan in place to guide us, we can reduce the chance of getting trapped in these loops.
Here is what we can do to avoid emotional torture. A plan is only as good as its inputs. We must educate ourselves. Put us in the shoes of that investor 10 years ago, facing two strong businesses out of an ocean of choices. Would we have the imagination to predict those business outcomes? Would we have the ability to hold on to these businesses during the times when the stock fell or went nowhere? What should we expect as a reasonable return? Would we sell when we have made a boatload of money after 8 years of holding? We would have made good money but without a plan in place, we would sell at the previous all-time high price and miss the future up-move. How much of our portfolio would we allocate to those two stocks? During this period, would we have a lot of equity or a lot of debt? So many choices to make and plan for.
This is where a plan is useful. We can then allocate based on the plan and only then can not worry too much about the outcome.
“So what, if that could have been me?”
It is hard to predict how we will feel about our investments when we are making them. We only need to remind ourselves of why we did what we did. After all that may be enough to make us feel better about “it could’ve been me.”
(The two stocks mentioned in this article are deliberately unnamed to meet compliance norms.)
Raunak Onkar is a fund manager and head of research at PPAS Mutual Fund.