Using the military mind on your investments

Posted by Ken Norquay - President, Mkt St Investment House

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Consequence of Error

Saturday’s tragic plane crash in Russia took the lives of many important military and government officials in Poland. And now the obvious questions are being asked: why were so many top officials on the same plane, whose fault was it, what can be done to prevent this type of national tragedy from happening again? We send our sympathy to our Polish friends.

But we also wonder about human nature. Is there some lesson we can glean from this event that will help us manage our own lives more prudently?

The key lesson from the Polish pilot’s now obvious mistake is to reassess our understanding of risk. What is risk? How can we realistically assess the risk in a situation before a tragedy? How can we avoid tragedy before it happens?

When I was a young officer in the Canadian Armed Forces, the pilot trainees were taught about the ‘consequence of error’: If I make a certain choice and that choice eventually proves to be an error, what will the consequences be? So if a pilot were advised to go to another airport because landing at this foggy airport was too acxdangerous, the consequence of using another airport would be that all his passengers would have to be bussed to the correct destination: they would all be late. And if he decided to try the landing in the fog, and that proved to be an error, the consequence would be a crash. Canada’s student pilots would have had no trouble making the decision to choose the alternative airport because of the huge difference between the two consequences of error.

In my book, Beyond the Bull, I discuss the use of the military mind in managing our investments. Let’s see if this applying the ‘consequence of error’ exercise can be used to help us improve our investment skills.

Financial planners and mutual funds salesmen tell us that we should buy good quality stocks and hold them indefinitely. The problem with this approach is that it hasn’t worked for ten years. Today, the Dow Jones Industrial Average is approximately the same as it was ten years ago. The Standard and Poor’s 500 Index is about 15% lower than it was ten years ago. Canadian investors did better: we made an average of about 2% per year for those same ten years. The investment industry’s choice ― buy and hold for the long term ― has turned out to be an error. And the consequence of making that error has been a sub-standard rate of return for ten years.

But what about the future? What would the possible consequences be if continuing to hold stocks for the long term proved to be an error? What if we simply sold our mutual funds and kept the money. What would be the consequence of that approach, if it proved to be an error?

Choice No. 1

If we continue to hold our equity mutual funds and that proves to be an error, we run the risk of losing our retirement nest egg. Twice in the past decade, the stock market dropped over 45%. It could happen again ― and if it does, the consequence of holding our stocks through that period is losing half of our retirement savings.

This problem applies not only to small investors. Big pension funds lost many billions of dollars of retirees’ money in the two monumental stock market declines of the past ten years. It’s not just about your RRSP; it’s huge. If the stock market drops again as it did in 2008-09 or 2001-02, it will seriously affect the retirement plans of almost all Canadians. This is the consequence of error of holding stocks when the stock market falls.

Choice No. 2

What if we sell out and that course of action proves to be an error? Selling out would be an error if the stock market went up and we were not invested because we had sold. The consequence of that error would be that we would earn only 2% or 3% on our cash instead of a much larger return if we had stayed in the stock market.

This ‘consequence of error’ exercise helps us develop judgement. In the case of the Polish airplane crash, there was an error in judgement that killed many people. In the case of stock market crashes, an error in strategy will affect the retirement plans of millions of Canadians. But the goal of the ‘consequence of error’ exercise is valid: to help us assess risk properly and to reduce the impact of the error in our lives.

Obviously we have more than just two choices in the investment world. I encourage investors to take advantage of the errors of other investors and to limit the effect of our own errors. Try to do what the mutual funds industry tells us can’t be done. Try to invest in securities that are rising in price and not in securities that are falling in price. Then we should plan the type of errors we want to make.

And what type of errors do we plan to make? Obviously, we are trying to not make investment errors. But, when we do make an error, we’d like it to be the type of error illustrated in Choice No. 2 above: an error where we earn a lower rate of return than we could have. And what type of errors do we plan not to make? The error shown in Choice No. 1: holding investments in down trends and losing our capital.

In a perfect world, we wouldn’t make errors. But we live in this world. And in the investment world, we spend a lot of time flying in the fog. So we need to plan our actions in full awareness of the consequences of possible errors ― and then be prepared to live with those consequences.

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