Some of the greatest businesses are defined by the chances they take to prevent the business from becoming stagnant. We see the successes but it’s the little failures along the way that drive their success.
That willingness to fail plays an important role in a business’s survival. In fact, the opposite often seals a company’s demise.
Creative destruction is a natural process that wipes out companies all the time. Complacency does too. Some of the greatest companies of the last century disappeared because management found unique ways to rest on their laurels.
The company finds early success doing something different, grows to an immense size, and becomes an industry leader. After a few decades, management becomes arrogant, complacent, and comfortable. Bureaucracy creeps in. Before they know it, some new upstart, more willing to take risks, has passed them by.
Sears, Xerox, and Kodak are three examples from a long list of once-great companies where management quit taking risks. They avoided the uncomfortableness of failure and ceased to stay relevant.
In business, you can make a good argument for mistakes like Steve Jobs’s Lisa or Power MacCube because the highly creative Apple environment that spawned them also produced big winners like iPod and iPhone. You can even justify those mistakes that have become the folkloric case studies in how-not-to-do-it courses in business schools all over the country, such as the Edsel or 45 rpm records or even New Coke. These failures, for all the valuable lessons that they teach us in hindsight about management blunders, are simply risks that just didn’t work out. Such miscalculations, costly though they might be at the time, are part of the price of staying in business. As Peter Drucker pointed out nearly fifty years ago, it is management’s major task to prudently risk a company’s present assets in order to ensure its future existence.
To stay competitive, companies need to experiment and try new things. Trying new things means failing at times. Those failures offer lessons that lead to future success.
Investing is no different.
Peter Lynch claimed that if you’re doing things right, you might make money on about 60% of your positions. So you’re losing about 40% of the time.
The key, however, is not how often you lose, but how much you lose compared to how much you gain because successes can outweigh numerous setbacks over time. While catastrophic failures need to be avoided at the portfolio level, diversification makes it easier to overcome deep holes created by any single position.
A perfect example of this can be found in any index fund. Since 1980 over 320 companies were removed from the S&P 500 index because of failure. The stocks of these companies suffered significant declines before being kicked out of the index. And yet, the S&P 500 shrugged it off. It’s followed a gradual upward path the entire time.
The Russell 3000 tracks the largest 3,000 companies in the U.S. It follows a similar pattern:
We analyzed all stocks that were members of the Russell 3000 at any time from 1980 to 2014, a database of 13,000 large cap, mid cap and small cap stocks. We then defined what we believe a concentrated stock holder would see as a catastrophic loss: “a decline of 70% or more in the price of a stock from its peak, after which there was little recovery such that the eventual loss from the peak is 60% or more.” How often does this take place?… 40% of all stocks suffered such a permanent decline from their peak value. Remember, we are not talking about temporary declines during the tech boom-bust or during the financial crisis, but large, permanent declines that were not subsequently recovered.
Yet, the Russell 3000 handled those failures admirably. The index grew at roughly a 12% annual rate over the 34-year period.
How is that possible? Because the outliers in both indexes are responsible for most of the returns. The performance of the most successful companies makes up for not only the little failures but the catastrophic ones too — with excess performance to spare.
The lesson: failure is common in investing. So common that you can fail frequently and still succeed. One could argue that if you’re not failing at least a little bit then you’re probably not taking enough risk. You’re missing out on lessons that could improve your investment process and future returns.
So embrace it. Little failures are a byproduct of long-term investment success.
- The Upside of Losing – J. Rekenthaler
- 12 Lessons on Money and More From Warren Buffett and Charlie Munger – Morningstar
- Mental Models to Help You Cut Your Losses – Behavioral Scientist
- Another Look at the Long-Term Trend in Real Rates – Klement on Investing
- Edward Chancellor on the Real Story of Interest (podcast) – MiB
- Investing in Influence – Sparkline Capital
- How I Turned $15,000 into $1.2m…Then Lost It All – Guardian
- How Online Mobs Act Like Flocks Of Birds – Noema
- How Toys Changed After World War II – History
- The TIME Project