A Counterintuitive Investing Lesson from A Prisoner of War

This article was originally published in LiveMint. Click here to read it.

Jim Collins in his best-selling book ‘Good to Great’, shares an interesting counter-intuitive insight which he refers to as ‘The Stockdale Paradox’.

This is named after Admiral James Stockdale, one of the most decorated US Navy officers, who was also awarded the Medal of Honor in the Vietnam War.

As a prisoner of war in Vietnam for 8 years from 1965 to 1973, Stockdale was tortured over 20 times, had no prisoner’s rights, no set release date, and no certainty of whether he would survive to see his family again. Despite all this ordeal, he survived, while many of his fellow prisoners did not.

How did he survive?

That is exactly what Collins asks Stockdale. “I never lost faith in the end of the story. I never doubted not only that I would get out, but also that I would prevail in the end and turn the experience into the defining event of my life, which in retrospect, I would not trade.”

Taking a few minutes to reflect, Collins probes further “Who didn’t make it out?”.

Stockdale had an unexpected response — “Oh, that’s easy. The optimists!”.

But didn’t he just say that you needed to have faith in the end of the story. Isn’t that how the optimists think?

Here is how Stockdale explains this inherent contradiction. “The optimists. Oh, they were the ones who said, ‘We’re going to be out by Christmas.’ And Christmas would come, and Christmas would go. Then they’d say, ‘We’re going to be out by Easter.’ And Easter would come, and Easter would go. And then Thanksgiving, and then it would be Christmas again. And they died of a broken heart.”

He then goes on to share a simple yet profound piece of advice. “This is a very important lesson. You must never confuse faith that you will prevail in the end — which you can never afford to lose — with the discipline to confront the most brutal facts of your current reality, whatever they might be.”

What a powerful lesson. While Stockdale had little to do with investing, this is exactly the ‘mindset’ that all of us as investors need to adopt.

The ability to stick to equities for the long run finally boils down to your faith that human progress, ingenuity and entrepreneurship will prevail in the end despite all the inevitable temporary setbacks. The recent invention of covid vaccines in record time is a humble reminder of our ability to innovate out of setbacks. We are simply betting that good entrepreneurs on aggregate will get rewarded with higher returns in the long run.

Justifying the faith, patient Indian equity investors have historically been rewarded with great long-term returns closely mirroring the underlying earnings growth of the companies.

So, the first key behavioural ingredient required for long-term equity investing is ‘faith in equities’.

However, in the short run, the Indian equity markets have experienced 10-20% temporary declines almost every year. Once every 7-10 years, there have been larger temporary declines of around 30-60% such as the covid crisis in 2020, global financial crisis in 2008, tech bubble in 2000, etc.

Most investors who have tried to avoid the pain of short-term declines by trying to time the markets have ended up with subpar returns as they usually stay out for too long in fear and miss out on the upside.

A better approach is to accept rather than wish away the inevitable declines and view it as an ‘emotional fee’ to be paid for reasonable long-term returns.

As the legendary investor Peter Lynch says, “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.“

This brings us to the second key behavioural ingredient required for long term investing — ‘Ability to Suffer in the Short Term’.

As investors, we need to accept both realistic pessimism about the short run and pragmatic optimism about the long term.

This will mean building adequate “room for error” via diversification (across asset classes, investment styles, sectors and geographies) to survive the short term while our long-term faith in entrepreneurs will help us stick to our plan patiently for a long enough period to benefit from the magic of compounding.

Sensible long-term investing finally boils down to the subtle art of balancing both these contradictory mindset:

• Faith in equities over the long term
• Ability to suffer in the short term

In other words, as Stockdale Paradox reminds us — “Have faith but confront reality.”