Has Your Portfolio Suffered an ACL Tear?

by The Graham Investor on January 18, 2014

The nastiest injury in sports doesn’t appear to have a lot to do with investing. You probably don’t give your Anterior Cruciate Ligament much thought unless you are a football, basketball or soccer player who has just torn it – an injury that is becoming increasingly common. Rehab of an ACL tear can take months – years even – and the knee joint is rarely the same, even with ACL reconstruction. Part of the problem is that this ligament sits in the middle of the knee joint and is bathed in synovial fluid which is known to contain enzymes that prevent blood from clotting – after all, you don’t want a blood clot in the middle of your knee; it would make it impossible to bend. This makes it extremely difficult for the ACL to heal naturally. Surgical repair is possible, but is also difficult to come back from.

Now we’re actually getting to the investing analogy – how does an investor recover from a single big loss? Virtually every investor is going to encounter such a career-threatening “injury” to their portfolio eventually; one man’s 5% loss might be another man’s 50% loss – it depends on the individual and how he or she copes with it – but both may be the investing equivalent of an ACL tear. The investor might not return. Or he might return and yet not be as good as he was before at making investment decisions.

The ACL plays such a crucial part in limiting the knee’s range of movement that it is very difficult to perform without it. Studies of NFL players who experienced ACL tears show that a fifth did not return, and those who did were as much as a third less effective, statistically speaking, as before. ACL rehab is not so much as rehabilitation of the knee as it is about re-education of the muscles around the knee to get them to contract and relax in time with the knee’s movements and prevent over-extension in planes of motion that were previously restricted by an intact ACL. It’s also about overcoming the psychological scars – learning to trust your knee joint again and expunge any lingering doubts that you can function at the same (or greater) level.

How to you recover from a potentially career-ending injury and come back better than before? You analyze what went wrong (bad movement), fix the problem it caused (repair/rehab), and avoid making the same mistake again. The latter is not difficult. The real difficulty lies in actually having the nous to publicly accept your mistakes and analyze them. Most people prefer talking about their successes; it is very difficult to get them to talk about their failures in public.

Talking about their failures is exactly what some of the greatest value investors do. Both Mohnish Pabrai and Guy Spier have made a point of talking more in their annual meetings about the bad investments they made – the stocks that turned out to be total dogs – rather than about the ones that made millions. What they are actually doing, it seems to me, is thinking out loud and analyzing why the investment went wrong. They do this in order to refine their investing checklists for next time. Neither is going to rely on a mental checklist to pick stocks; there are simply too many factors to remember every time.

Atul Gawande, in his book “The Checklist Manifesto”, writes entertainingly about his work on hospital operating theater checklists and how they have saved many lives. He also writes about the origin of aviation checklists and how they have similarly saved lives by preventing accidents. How many of us would undergo major surgery or fly on airplanes nowadays if we knew the surgeons or pilots were not using checklists? Probably not many. Yet many people pick stocks on a whim and, when they lose money, put it down to the market misbehaving rather than any fault on their part. Yes it is quite possible they do have a sound, comprehensive mental checklist from years of investing. But perhaps they missed a step or two? Perhaps they need to add more steps? This can only be done by refining the checklist which, in turn, can only be done by a thorough analysis of the losers. There’s a pattern here.

True, investing is not the same life or death activity as performing brain surgery or flying an airliner. But consider this, neither Pabrai nor Spier have many losers. In fact it has become increasingly rare for Pabrai to lose money on an investment due to an adherence to continuous refinement of his checklist.

Here are a couple of places to start if you’re interested in creating and using an investing checklist:

David Parmenter has a nice Buffett-style checklist here.

Michael Shearn’s book “The Investment Checklist: The Art of In-Depth Research” has a very comprehensive list near the end.

The Checklist Manifesto: How to Get Things Right” by Atul Gawande

How the Pilot’s Checklist Came About

“Discipline is hard – harder than trustworthiness or skill and perhaps even than selflessness.We are by nature flawed and inconstant creatures. … We are not built for discipline. We are built for novelty and excitement, not for careful attention to detail. Discipline is something we have to work at.”                  — Atul Gawande, “The Checklist Manifesto”

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