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House cleaning time

Diwali is a time to buy new things, but before that, it's a time to clean out old junk

House cleaning time

Diwali is the time of the year to buy new things. Are you planning to do that in your investments too? Actually, you should remember that it's also the time of the year to throw out useless things. When Diwali approaches, first comes the time to clean the house, get rid of the junk and only then buy nice new things. Cleaning is a higher priority.

I would say that as investors too, that's also what our priorities should be. Cleaning out dud investments should get a higher priority than identifying new ones. I don't know any investor (myself included, at least in the past), who doesn't have some completely dysfunctional investments on their books which are long past their sell-by date. In the old days, selling often meant a combination of cumbersome paperwork along with a mental block against confronting bad decisions made in the past. Now, the paperwork is no longer there, selling anything is just a few clicks away, but the rest of the reasons for procrastination remain.

While plain old procrastination is certainly one reason why many of us will not embark upon this Diwali house cleaning, there's a fear of admitting failure too. Admitting failure is a difficult thing to do for almost everyone, whether in investing or in anything else. The tendency is always to go on pretending that some miracle will happen and we will not have to recognise - more to ourselves than to anyone else - that we picked a loser. A classic case of the sunk-cost fallacy.

In 2011, Nobel Awardee Daniel Kahneman, who made behavioural economics a widely known idea, published 'Thinking, Fast and Slow', which laid out his ideas in an accessible form. The sunk-cost problem is introduced in the book thus, "Two avid sports fans plan to travel 40 miles to see a basketball game. One of them paid for his ticket; the other was on his way to purchase a ticket when he got one for free from a friend. A blizzard is announced for the night of the game. Which of the two ticket holders is more likely to brave the blizzard to see the game?"

As readers, we immediately know the correct answer: the fan who paid for his ticket will be more determined to see the match because 'he has more to lose'. However, even as we articulate our answer, we realise the flaw in it. The money is already gone. Taking the additional risk of driving in a snowstorm will not get it back.

For equity investors, no one has got it for free, but the underlying principle is the same. Unlike the sports match, there is no expiry date, so as long as we can avoid selling, we feel that the loss is not yet made. In an accounting sense, that's actually true. However, in practice, it is not. More than the accounting entry, it's important that we investors admit failures instead of just kicking the can down the road. A failure is an opportunity to understand and learn, just waiting for a miracle is an illusion. As fund management legend Ray Dalio said last year, "Everyone has weaknesses and they are generally revealed in the patterns of mistakes they make. The fastest path to success starts with knowing what your weaknesses are and staring hard at them."

Examining our investment portfolios and then separating out the garbage - just the way we clean our house before Diwali - is the best way of staring hard at our mistakes. That's where the roots of future success lie.

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