The Serenity Prayer:
God, give me grace to accept with serenity the things that cannot be changed,
Courage to change the things which should be changed,
and the Wisdom to distinguish the one from the other.

Looking back at 2023, I want to borrow the spirit of the Serenity Prayer and make a version of my own to summarize what I learned from the year:

Be tranquil and accept reality.
Be courageous and seek truth.
Have the fortitude to do both at the same time.

Separate Thoughts From Emotions

Something that came to me often during 2023 is the idea of separating thoughts from emotions. For most people, their thoughts and emotions are interconnected. Even if they can more or less identify and distinguish between the two, separating thoughts from emotions is particularly challenging.

Emotions lead to thoughts. Experiencing a moment of intense joy, such as a streak of successes at doing something, can lead you to think you are really good at doing this thing. Feeling a moment of intense fear, such as hearing a strange noise behind you when walking alone at night, can lead you to immediately think “am I being followed?”

Thoughts lead to emotions as well. Ahead of a major business meeting, the thought of “I might mess up in front of all these important people” can lead to feelings of anxiety and nervousness. Thinking about past successes of “I worked hard and achieved something great” can lead to feelings of pride and happiness.

Emotions lead to thoughts and thoughts lead to emotions. The fact that emotions and thoughts are frequently mixed together results in troublesome behaviors. So, at times, emotions can run so high that one cannot help oneself but do things that one otherwise would not do. That is one of the reasons why the stock market continues to fluctuate, dotted with panic bottoms and euphoria peaks. It is a human condition that most people just cannot stop themselves from selling stocks in a panic and buying stocks in euphoria.

The notion of separating thoughts from emotions is complicated by at least one other psychological consideration. Rather than separating thoughts from emotions, some people simply suppress their emotions. This seems to be particularly common among men. “How are you doing?” “I am doing very well!” (Pretending to be) Doing well seems to be the only answer that is socially acceptable. Trying to separate thoughts from emotions by suppressing emotions can lead to pent-up mental stress, unhealthy lifestyles, and declining overall wellness.

Given most people are unable to separate thoughts from emotions and given the additional complications such as suppressing emotions (unhealthy), for an investor who can truly separate thoughts from emotions in a healthy and sustainable way, that ability represents an unfair advantage in investing. Rare. Significant. Enduring. It would allow the investor to take advantage of panic bottoms and euphoria peaks, by seeing it and catching it, rather than just living in it.

Distinguish Odds From Payoffs

Odds represent the probability profile of an outcome, the chance of losing and winning. Payoffs represent the potential returns, usually expressed through a probability-weighted average number. In 2023, I came to appreciate more and more the difference between the two.

Most of us were trained to calculate payoffs and think in payoffs. For example, a stock is currently trading at $4 a share and, over the next 12 months, it has a 50% chance of going up to $10 a share and a 50% chance of going down to $0 a share; therefore, the expected stock price is $5 a share (10×50%+0x50%) and the expected return of this investment is 25% in a year (5/4-1).

This approach sounds logical. In reality, however, it can misguide investors and bring them severe harm. Let’s continue with the same example. An expected return of “25% in a year” is highly attractive. So, should a sound investor put all his or her life savings into this “25% in a year” investment opportunity? Of course not! No sensible investor would want to take the risk that, with a fifty-fifty chance, her life savings will go to zero in a year. Then, should a sound investor invest 50% of her savings in this thing? Or 30% of her savings? Or 20% of her savings? The answer for most people is no.

That is the point that I am trying to make here. In investing, we should not use payoffs to guide our thoughts. Many investment ideas — like this “25% in a year” — look highly attractive on the surface with their payoffs. But underneath the grand edifice hides a non-negligible downside risk that can permanently harm an investor — the odds are horrifically bad. Therefore, I believe, investors should appreciate the difference between odds and payoffs. Instead of thinking in payoffs, think in odds.

Think about it a bit more. There is an irony here. The “payoff” framework that was taught to us as the orthodox way of thinking about investing is actually more suited for casino gambling. Yes, casino gambling. Most people gamble by spreading their bets across a large number of attempts of roughly equal sizes. In a casino setting of gamblers making small and repetitive bets, that “payoff“ framework actually works. For example, blackjack if played skillfully has a better payoff profile than most other casino games; slot machines, however, have a predetermined payoff profile that gamblers will certainly lose in the long run no matter how hard they try; for skilled gamblers, they should spend more time on blackjack tables than in front of a slot machine. So, to have a better gambling outcome in a casino, the “payoff” framework investors were taught at school is the right one to follow. Alas. We were taught a framework to excel at gambling, not at investing. What an irony.

Differentiate Large Mistakes From Small Mistakes

It has become increasingly obvious to me that in investing, small investment mistakes should be welcomed. There are several reasons. One, small mistakes are inconsequential. Losing a few bps of total assets in each bet across many different bets makes little difference to a portfolio. Two, mistakes contain information. They help me learn and improve. By making small mistakes frequently, it serves as a frequent reminder to myself of how difficult the investment game is and how I am not as good as I think I am — both benefit me by helping me stay disciplined. Three, there seems to be some limited empirical evidence, based on actual investor experiences, that in order to arrive at the best winning ideas, one has to churn through a large number of losing ideas. So, keep mistakes frequent but small.

It is equally apparent to me that large investment mistakes should be avoided at all costs. There are at least two reasons. One, compounding is powerful in both directions. In a positive compounding experience, the last doubling creates the same incremental wealth as the total wealth of the entire prior history: 1, 2, 4, 8, 16, 32. From 8 to 16, the incremental 8 equals the prior value of 8. From 16 to 32, the incremental 16 equals the prior value of 16. In a negative compounding experience, a large loss incurred today can eliminate years or even decades of investment gains. If one suffers a 50% drawdown at the value of 32, that is a loss of 16, which equals the prior value of 16 — i.e., a large loss today can eliminate all the wealth accumulated over the entire prior history. Looking back at the past two years, we have seen some prominent investors suffer horrendous drawdowns that in dollar terms, they have lost a meaningful part, if not all, of the investment gains they have ever made in their entire investment careers. That is alarming and extremely unfortunate.

The other reason why large mistakes should be avoided is the “opportunity cost” of committing them: a losing period means additional time is needed to recover from the drawdown; a losing bet means the same capital would have been invested differently and might have produced better results. By making large mistakes, investors are losing on time and losing on returns. Those are why I think large mistakes should be avoided at all costs.

In short, by encouraging small mistakes and discouraging large mistakes, investors can encourage positive compounding and discourage negative compounding.

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