The nirvana fallacy

Perfection is the enemy of the good. This is a saying that appears in many forms in many cultures and languages. The idea is simple: if you keep looking for something that is perfect, you will end up rejecting what is good enough. There is also the concept of the 'nirvana fallacy', which amounts to comparing perfect, unrealisable ideal situations to something that actually exists.

This is a big problem in investing. Some years ago, I wrote about a certain style of analysis that some mutual fund experts had adopted. They would go through the past portfolios of equity mutual funds and hold up examples of stocks that the fund had bought but which had not done well. This was then used as an example of the poor quality of fund management. The problem with this approach is that it completely abandons the idea of an investment portfolio and of the value of diversification. It's a perfect example of the nirvana fallacy.

When you are evaluating an investment portfolio, then there are going to be some stocks that do not do well. At Value Research, we have always had the approach that perfection is not possible. If you aim for perfection, you will be immobilised into inaction and your money will spend a lot of time sitting in a savings bank account. Value Research Stock Advisor is now three years and four months old. During this time, we have recommended a total of 48 stocks, out of which 40 are currently in our 'Buy' list. We have had a few stocks that have done badly. A bulk of the stocks have done well and a certain set of stocks have done extremely well. All in all, our recommendations have done well.

I and my team analyse the failed recommendations and make sure that we have learnt the correct lessons from them. In fact, we have specifically rejected some stocks that looked good but had a key resemblance to some of our past failures.

However, as an investor, I do not worry about the failures. Of course, I am personally invested in all the stocks we recommend and I'm fine with the ones that have done badly. There has never been a portfolio which, over a sustained period of time, does not have some bad stocks in it. That is the way equity investing works. The solution to this is obvious: the oldest risk-control measure in the world, which is diversification. The theory of diversification is very simple. All investments don't work well simultaneously. The normal state is for some investments to do well and others to do not so well or even badly at a given time. If you happen to be over-invested in something that is doing badly at a time and not at another, then you are going to have a problem. The utility of diversification is in saving you from poor performance in a narrow set of investments. If a particular company or sector is in problem, having only a limited exposure to it helps. Apart from sectors, diversification should also be across company size as sometimes only smaller or larger companies do well or do badly. It can also be geographical, which involves investing in foreign stocks, but that's a separate story.

This is the theory but it does take some care to implement it in your investments and then to make sure that it stays implemented. For those Stock Advisor members whose main source of investment ideas is Stock Advisor, it's as simple as investing in all our recommended stocks, which is what I do personally. However, that's a pretty large set so if you are building up to it gradually, then the subset of those stocks, our 'Best Buys Now' list, is good enough. One of the goals of Best Buys is specifically to suggest a smaller set of companies that is easy to invest in for those who are just starting off.

What if you want to invest in only one or two or three companies that you choose from our set? Obviously, we can't stop you because at the end of the day we are just doing research and communicating the list to you. If you are confident of what you are doing, and you have other stocks that you have researched yourself in your portfolio, then that's fine. Otherwise, the 'My Investments' tool on Value Research Online is a great way to automatically analyse the degree of diversification of your investments. Parameters like stock exposure, sector exposure, exposure to a range of capitalisations as well as geographical exposure are all taken care of in this tool.

This kind of numbers-driven dispassionate analysis plays an important role. It shows you the underlying patterns. For example, at some point, it may show you that all small-cap stocks are doing less well than the large caps. Instead of just blaming individual stock selection, this points to the fact that this is a phase in the markets and tomorrow it could be the other way around. There is balancing, a trade-off, that is going on here. This is a portfolio, not just a collection.

By using Value Research Stock Advisor as your source of investment ideas and by using our 'My Investments' tool on Value Research Online, you can easily bring order to the chaos of equity investment, understand what to do and why to do it.