Why it's OK to be wrong

When it comes to the stock market, many investors hate the idea of being wrong. They think poor investment decisions must be avoided at all costs.

Well Intelligent Investor Share Advisor wants you to embrace it. The stock market is no place for perfectionists and being wrong – as you'll see – is completely normal. Better still, it won't stop you being a successful investor.

Human beings that we are, we tend to judge our investing performance in several ways. First, we look at what share prices are doing, mainly because it's easy to anchor to them. And second, we compare ourselves to others. Both are poor ways of judging performance, except over the very long term.

Wrong timing

Consider BlueScope Steel. We were unambiguously negative on the steel producer between 2002 and 2008, a period over which it rose fourfold thanks to the 'stronger for longer' mining boom. Seven years of us being 'wrong-er for longer' might seem pretty damning, but we didn't waiver and eventually BlueScope's share price tumbled 93% precisely because of the fundamental problems we highlighted during the boom.

Of course it would have been nice to ride the stock up and sell out at the top, but while it was clear there were serious problems, it was impossible to say when they would come to the fore, so the best course was to avoid the stock entirely – which meant being wrong for a while before being right.

Even RHG Group, one of Share Advisor's more successful recommendations, severely tested shareholder patience. After our upgrade to an outright Buy in 2007 (following Speculative Buys at higher prices) the stock fell almost 80% before making it all back four times over.

RHG, BlueScope and countless other recommendations show that adverse share price moves in the short to medium term are commonplace. Indeed, you should expect to get your timing wrong.

Wrong stock

You should also be happy with imperfect stock selections. Consider the choice between supermarket operator Woolworths and cancer treatment company Sirtex Medical in August 2011. Let's say you purchased Woolworths on 9 Aug 11 (Buy – $23.89) but your neighbour, who also subscribes to Intelligent Investor, purchased Sirtex a few weeks later on 29 Aug 11 (Speculative Buy – $4.95).

Comparing yourself to your neighbour three years later, you might feel a little envious. Woolworths' share price has risen 43%, considerably below Sirtex's 358% increase. So did you buy the wrong stock?

No, you didn't. You managed to overcome a difficult market in 2011, buying Woolworths – one of Australia's highest quality businesses – during the downturn. Presumably you also bought Woolworths because it was less risky than the alternatives, including Sirtex. And while three years is arguably too short a period to judge, Woolworths has outperformed the All Ordinaries Index. Within that context, it looks like an excellent selection.

So if you needn't worry about poor timing, and you shouldn't concern yourself with the stocks others are buying, what should you worry about?

Wrong valuation

In a word: valuation. Time spent valuing a company is time well spent. Consistently purchasing stocks with a decent margin of safety is your passport to excellent performance. Buying high quality, underpriced companies, then holding them for many years, is the best way we know to generate above-average returns from the stock market.

Even coming up with wrong valuations need not be fatal. In fact, there's a kind of insurance policy you probably already use: your portfolio. A properly constructed portfolio is specifically designed to prevent any individual decision from doing too much damage.

Take QBE Insurance, one of Share Advisor's more problematic recommendations of recent years. Originally upgraded in QBE's quality assurance on 24 Mar 09 (Long Term Buy – $19.10), the suggested portfolio limit rose from 5% to 7% as the share price fell. Sticking to these portfolio limits, an investor would have lost a maximum of 2.6% of his portfolio on the stock by the time QBE downgraded to Sell was published on 29 Jul 14 (Sell – $10.56).

Averages matter

So here's the point: Individual decisions matter less when you maintain a properly constructed portfolio. Obsessing over errors – known as loss aversion (see box) – isn't helpful. Focus instead on the average performance of your portfolio, as the very reason for its existence is to smooth out the bumps.

Table 1, a hypothetical portfolio, makes the point. Focusing too much attention on Stock B's 50% decline ignores the fact that Stock C has risen 150%. In total the portfolio is up 16%, even though only two of the five selections have risen. It's why we've recommend mini-portfolios of speculative gold shares (see AU, check out this gold portfolio from 6 Nov 13) or mining services stocks (see Time to buy mining services? from 26 May 14). Individual stocks in these mini-portfolios might perform poorly but the occasional big winner should make for a good overall result.

While being wrong isn't something to be afraid of, you should still try to minimise errors.  Spend time on the following to improve your average performance:

• Value stocks carefully and buy them only when they offer a considerable margin of safety;
• Focus on high quality businesses, then own them for a long time;
• Maintain a well diversified portfolio with strict limits;
• Understand that 'speculative' implies potential poor returns in individual stocks;
• Be aware of your own psychology (are you too averse to losses?)

Investing is one of the few endeavours where you can make regular mistakes and still produce excellent results. Embrace being wrong: it's the right way to run your portfolio.

Note: Our model Growth and Income portfolios hold shares in Woolworths.