What is worse in investing: Type 1 or Type 2 errors?

Every investor must answer two questions. The first is whether to buy a business or not. And the second is whether one should continue owning a business after it has been bought.

In answering these questions, one effectively bets on one possible future. The future is inherently unknowable and so mistakes are inevitable. There are two kinds of errors in research: Type 1 and Type 2. Type 1 error is when one incorrectly rejects the null (status quo) hypothesis. Type 2 error is failing to change one’s view when the facts have changed. 

Type 1 error in investing might mean being too quick to buy into a stock (action bias) or wrongly deeming the thesis broken for a portfolio holding in the face of bad news (selling low). Type 2 error might mean being too slow to buy into a stock even when facts suggest it’s a winner (not taking a swing), or engaging in thesis drift and failing to cut one's losses (closed mindedness).

Society seems to focus on minimizing Type 1 errors (judicial system has an innocent until proven guilty approach) but minimizing Type 1 errors (almost always) leads to higher rates of Type 2 errors. This raises a question: “What is worse in investing? Type 1 errors or Type 2 errors?”

I have posed this question to multiple investors and none have given a straight answer. Beyond continuously evaluating (and re-evaluating) one's view, there is one common thread: put risk before reward and try to buy good businesses with a margin of safety. 

This requires discipline and patience but it is worthwhile. The quality hurdle gives you the courage (willingness) - and margin of safety gives the cushion (ability) - to live through periods of subpar business performance. If you do this it is easier to give longer rope when the going gets tough - for inevitably it will.