Thinking Clearly About Stock Decisions
On the other side of the trade, bias, conviction, and valuation
Investing successfully, meaning outperforming the market over the long run, is incredibly difficult.
The universe of stocks to choose from is essentially infinite, while your capital and, more importantly, your time are not.
Finding ideas is hard, building true conviction is hard, and refusing ideas is hard.
Conviction is dangerous and can be deceptive: your input determines your output. If you read only bullish analyses about a stock, your conviction will grow stronger. Add an existing bias, and you will fall in love with a stock.
Aswath Damodaran explains that you’ll always be biased about a stock no matter what:
“You almost never start valuing a company or stock with a blank slate. All too often, your views on a company or stock are formed before you start inputting the numbers into the models and metrics that you use and, not surprisingly, your conclusions tend to reflect your biases.”
The quote continues with Damodaran explaining that the bias starts when you choose the company to value, which isn’t a random choice. You heard a good story about this stock somewhere. Then you start reading news articles, annual reports, analyst reports, etc., all of which fuel your bias.
Because you feel so positive about the stock, you start bending some rules. The valuation does not work at the current price, so you make it work. You bump up revenue growth in your model, maybe assume a bit more margin expansion, and voilà, the valuation suddenly works.
When the stock dips, you do not start doubting, at least not really, so you buy another chunk. After all, you are very bullish.
You probably see where this is going. Some of the biggest challenges in investing are psychological, and I have struggled, and still struggle, with them.
As investors, we must be meticulous in our stock-picking process. We must recognize and understand our biases, and we must try to kill our stock ideas, much like entrepreneurs try to kill their business ideas while validating them.
None of this is solved by intelligence, or stronger opinions. It’s solved by structure.
In this post, I break down some core failures investors can make and how you can avoid them.
For every buyer, there is a seller
For every buyer of a given stock, there is a seller.
Common sense, yes, but it’s something we ignore too often. Whenever you buy a stock because you think it’s undervalued, someone else sells because they think it’s overvalued.
There is an important difference of opinion at play, another side to every trade that you must understand.
Since the market is mostly efficient, you have to assume most market participants aren’t stupid. They have their reasons for selling a stock. And if you don’t understand those reasons, you shouldn’t buy.
Every investor has access to the same information, but investors make different decisions based on that information.
They process information differently. Simply put, one investor could interpret an earnings report as positive, while another could view it as negative.
The point is that a buy decision is only justified if you understand why a rational seller is willing to sell at that price.
There are some lazy assumptions investors make when we buy stocks: if you see undervaluation, the market must be wrong, and the person on the other side, the seller, must be uninformed or acting on emotion.
These can be dangerous assumptions.
You have to step into the shoes of the seller and understand why the market is doing what it’s doing. When a stock is declining, understand all the reasons why, and then validate why those reasons are wrong, in your opinion.
Only when you’ve taken a serious look at the seller’s side, and still believe in your thesis, buy.
Borrowed conviction
I came across an amazing quote in one of Howard Marks’ memos:
“The greatest enemy of knowledge is not ignorance, it is the illusion of knowledge.”
—Daniel J. Boorstin
It got me thinking.
Most of my stock ideas come from colleagues—that is, other writers here on Substack. There are some very talented people on this platform, and the number of stock ideas shared here is more than enough to fuel a large backlog.
And while there is a case to be made that the investing Substack community is more experienced than average, reading all these writeups, including mine, plants a bias into your head before you do the research yourself.
Remember Damodaran?
The problem is that if you start researching a stock after reading a lot of positive stuff about it, your own analysis starts after conviction has already formed, not before.
This means you end up analyzing the stock through rose-tinted glasses. You’re borrowing conviction from someone else.
That doesn’t mean you should stop reading stock writeups, please don’t. But it does mean you need to be cautious. Most importantly, when you analyze a stock you’ve read about, you must try to disconfirm that writeup or analysis.
Kill the idea, don’t nurture it.
What “exceptional” actually means
If every stock purchase is a disagreement between buyer and seller, and conviction is mostly borrowed, then the hurdle to buy has to be high.
This is where the idea of “exceptional” stocks matters.
By exceptional, I don’t mean a label for businesses with good metrics or attractive narratives. Those are your typical high-quality companies, like Microsoft, Visa, and Berkshire Hathaway.
These stocks are easy to find. Run a “high-quality” screener and you’ll find plenty, especially once conviction has already formed. But they don’t protect you from being wrong for the wrong reasons, such as borrowing conviction, not understanding the seller’s side, or relying solely on surface-level quality metrics.
The exceptional hurdle is a standard the idea has to survive.
For a stock to be exceptional, I need to understand it well enough to engage honestly with the other side of the trade. That means being able to explain why a rational seller is willing to sell, and where my view differs. If I can’t do that, my conviction is likely borrowed, not earned.
That immediately makes exceptional personal. A business outside my circle of competence cannot be exceptional to me, no matter how strong the numbers look. If I don’t understand how it can fail, I have no business owning it.
Exceptional, then, is not just about finding great companies. It’s about understanding the other side of the trade, building your own conviction, and staying as unbiased as possible.
Valuation as a constraint, not a justification
Valuation is the final door you must open before reaching your destination—that is, purchasing the stock you’ve been researching.
As a result, you want to open that door oh so badly, especially when you’re biased and full of conviction (whether your own or someone else’s).
Remember what I said earlier? When you feel very positive about a stock, you start bending rules.
Damodaran calls this post-valuation garnishing, a process where you increase your estimated value by adding premiums for “the good stuff,” like synergy, control, and management quality. Essentially, you’re tinkering with the model until it says what you want it to say.
But here’s what’s critical: valuation, that final door, is supposed to be steel-reinforced, with many locks.
Valuation cannot be a justification to buy a stock. It must be the constraint.
If everything about a stock looks great—which is rare but can easily seem that way through those rose-tinted glasses—yet the valuation doesn’t work, that’s the end of the story.
That doesn’t mean you should drop the stock. Keep an eye on it, but wait patiently.
When Charlie Munger said, “The big money is not in the buying and selling, but in the waiting,” he wasn’t just talking about holding stocks. He also meant waiting for the right time to buy.
Valuation’s job is to limit your enthusiasm and ground your thesis in reality.
In practice, many investors, myself included, are too lenient on valuation. You want your stock idea to work, and you don’t want all the hours you’ve poured into research to be in vain.
Importantly, as a writer here on Substack, my incentives have been in conflict from the start. When I put hours of work into bringing you an interesting stock idea, I want that article to be of immediate value to you.
My incentive, therefore, is for the valuation to work. But me as the investor doesn’t have this incentive, at least not to the same degree. I now understand and appreciate that stock ideas can still be extremely valuable, even if they’re not actionable right away.
Building a catalogue of great stocks to own when the price is right is a good idea. Not every stock’s valuation has to work from the start.
This is an important reminder that valuation matters, a lot.
The takeaway
Investing well is not just about finding more ideas. It’s also about killing them.
Most mistakes don’t come from buying bad businesses. They come from borrowed conviction, from not understanding the other side of the trade, and from letting valuation justify what conviction already decided.
Stay skeptical, say no to most ideas, and slow down when you’re reading only bullish writeups.
If you haven’t noticed, this post is as much a message to myself as it is to you. We learn together.
Thanks for reading.
Lucas
Author & Founder, Summit Stocks
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Disclaimer: the information provided is for informational purposes only and should not be considered as financial advice. I am not a financial advisor, and nothing on this platform should be construed as personalized financial advice. All investment decisions should be made based on your own research.
Well said. On the other side of making money is losing it.