The Best Investment Mistake You Can Make

By Steve Ciaccio

Every decision that you make in your life brings with it two types of potential errors, one can be fatal, and one that involves a lot less risk.

Back in business school, one of my professors explained it with this simplified example: You are the captain of a Navy ship during wartime and your SONAR operator hears a ping. You have two choices of how to react, either fire a torpedo or not fire a torpedo. There are two general mistakes that you can make. The first mistake is that you fire a torpedo thinking that the ping is caused by an enemy submarine, only to later find out that you blew up a whale. The second mistake is that you do not fire a torpedo, assuming that the ping is caused by a whale, only to later find out that it was an enemy submarine. You missed your chance to protect yourself and now you are potentially doomed. These two potential mistakes are called type one and type two errors. In reality, the ping could have been caused by something other than a whale or an enemy sub, but this simplified example makes a good point.

Fortunately, not all decisions in life have such dire outcomes. However, this simple logic can make the most muddled situations easier to sort out. How do we apply it to our investing philosophy? From one perspective, you can say that a type one error would mean that you are not invested when an investment went up in value. The error that you would make is to miss out on the growth, but your principal is protected. With a type two error, you would be invested when the investment loses value, so you take a loss. You decided to not protect yourself when the ping was actually an enemy ship.

A philosophy that we use at our firm is one of “Advance and Protect.” All investing involves risk, including risk of loss of principal. However, there are times when the potential rewards of investing seem more likely, and times when the potential risks seem more ominous. It is more logical to invest in the stock market when we believe that we are in a period of foreseeable sustained growth, and to move out of the stock market when there is risk of economic slowdown or a potential market downturn begins to come into view.

So how do type one and type two errors relate to the current situation? With the European debt crisis unresolved, U.S. debt uncomfortably high, and persistent high unemployment, there is a good chance that the ping on the SONAR screen could be something that is worth avoiding. At this time, it seems that the best mistake is to make a type one error, which means to stay on the sidelines for now. By doing so, you would potentially miss out on a stock market upturn, but you would protect yourself against the risk of loss of principal. It also makes sense to keep those sidelined assets liquid and accessible. If history continues to repeat itself, there will be other opportunities in the future to participate in stock market growth.

If you would like to discuss this strategy, your call is welcome

Steve Ciaccio, MBA, CPA, is a Registered Representative with and securities offered through LPL Financial. Member FINRA/SIPC. He can be reached at 630-454-4599. Steve.Ciaccio@LPL.com.

The opinions voiced in this material are for general information only and are not intended to provide specific recommendations or advice for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. Stock investing involves risk including loss of principal. No strategy ensures success or protects against a loss. Past performance is no guarantee of future results.

There is no assurance that the techniques and strategies discussed are suitable for all investors or will yield positive outcomes.

Copyright Steve Ciaccio 2011