As we've discussed, the weight of evidence suggest that it's possible to systematically beat the market over time, but that's not to say that it's easy - far from it. It requires a focused strategy, hard work and discipline. However, not enough attention is given to the importance of also having a good investment process. Over an investing lifetime, you are likely to make hundreds of investment decisions, maybe more. Some of those decisions will be successful, while others less so. Clearly, learning from these past decisions has the potential to massively improve future performance but all too often we draw the wrong lessons or don't draw them at all. We judge decision quality by their outcomes (which may be luck), not by the process by which they were made...
This is an example of a well-documented behavioural tendency. Outcome bias means that we tend to judge a past decision by its ultimate outcome instead of based on the quality of the decision at the time it was made, given what was known at that time. As one study has shown, if a doctor performs an operation and the patient survives, then the decision is rated as significantly better than if the same operation results in the patient's death. But, actually, that's crazy if you think about it - the correctness of the doctor's decision to perform the operation should not be a function of the outcome, since clearly the doctor couldn't have known the outcome before the event.
Investment Outcomes: Skill vs. Luck
There's a really excellent paper by Michael Maubossin, which talks about the nature of skill and luck. As he notes, unlike chess or the lottery, investing is a hybrid animal in that its outcome is a function of both. That is one of the reasons why it is so difficult to identify if an investor has any skill. A novice investor can be lucky - the 'hot hands' phenomenon - while a skilled investor can have periods of under-performance (e.g. Bill Miller). This is what Buffett was getting at when he said that you don’t know who’s swimming naked until the tide goes out.
Outcomes are skewed by Luck
Focusin on investment outcomes leads many into the trap of being "fooled by randomness" (in the words of Nassim Taleb). That explains why many people are sucked into investing in the latest "hot" investment fund, based on fantastic past performance, only to find that the fund massively underperforms going forward, as the fund reverts to the mean performance over a longer timeframe. There may have no skill there in the first place, just a random roll of the dice.
There's an interesting blog post that illustrates the point by Paul DePodesta, a former baseball executive who features in Michael Lewis’s Moneyball (now a movie by Brad Pitt). He talks about playing blackjack in Las Vegas when a guy, sitting on a seventeen, asks for a hit. Everyone at the table stops, and even the dealer asks if he is sure. The player nods yes, and the dealer, of course, produces a four. As DePodesta relates:
"The place went crazy, high fives all around, everybody hootin' and hollerin', and you know what the dealer said? The dealer looked at the player, and with total sincerity, said: "Nice hit." I thought, "Nice hit? Maybe it was a nice hit for the casino, but it was a terrible hit for the player! The decision isn't justified just because it worked."
In a completely different sphere, Former Treasury Secretary Robert Rubin made the same point in an address to Harvard University:
"Any individual decision can be badly thought through, and yet be successful, or exceedingly well thought through but be unsuccessful because the recognized postulate for failure in fact occurs. But over time more thoughtful decision-making will lead to better overall results, and more thoughtful decision-making could be encouraged by evaluating decisions on how well they were made rather than on the outcome".
How we can improve outcomes through process
Obviously, what ultimately matters is outcomes (i.e. how much money did we make?), but one of the interesting ironies of most activities is that if you focus on the outcome, you’re less likely to achieve it. There is nothing much we can learn from random luck, as it has no predictive power. But the underlying process we can and should study. As Maubossin points out, all other things being equal, generally:
- Bad Process, Bad Outcome is inevitable in the long term.
- Bad Process, Good Outcome will result from luck (a short term phenomenon).
- Good Process, Bad Outcome will result from luck (a short term phenomenon).
- Good Process, Good Outcome is likewise nevitable in the long term.
One of the trickiest things about investing is determining when a bad (or good) result stems from a mistake (a process error), or just from bad (or good) luck, but that determination is crucial if we are to learn effectively for the future.
The Heart of the Investment Process
In essence, investing is just a process to identify, analyse, buy and sell under conditions of decision-making uncertainty. It can be broken down into, say, the following 10 steps. Each of these steps can easily be broken down in detail into further steps/questions (some of which are listed below), and then optimised for improved results.
- Defining your Investment Strategy: Are you focused on value, growth, income or momentum? Small-cap vs. large-cap? What's your "edge" (analytical, psychological or institutional) and how are you leveraging it? Have you defined your circle of competence?
- Creating an Effective Search / Origination Strategy: How do you create your "funnel" of investment targets? Are you spending time on the right companies? Are you able to filter out the low probability time-wasters while not missing out on potential targets?
- Deciding on your Investment Criteria: Are these investment criteria primarily quantititative or qualitative? What factors are most important? Have they been back-tested? If not, what are they based on?
- Evaluating & Valuing Those Targets: Do you have a systematic research process to evalate targets, including red flags? What's your valuation methodology? Have you decided on a margin of safety?
- Making a Buy/No Buy Decision: Do you use decision checklists to aid memory, as well as help manage complexity and emotions?
- Deciding on Portfolio Allocation: Do you understand the inter-related risks between your different investments? What is the opportunity cost of this investment versus others you hold or could hold?
- Monitoring Investments: At the time of purchase, do you write down and then regularly review your investment thesis? Do you look for disconfirming evidence that challenges it?
- Managing Event Risk: Are you alert to the possibility of risks already identified as part of your thesis? Are the risks product, competitive, economic, macro, leverage? Are you on the lookout for new ones?
- Know When to Sell: Do you keep the right mindset with regards to Mr Market? Are you swayed by loss aversion? Do you use a stop-loss or stop-time technique?
- Review, Learn, Rinse & Repeat
Most investors don't spend much time thinking about their investing process - it all tends to be somewhat ad-hoc based on a "hot tip" here or a chance new idea there. The thrill of the chase for the next 10-bagger is all that consumes them, whereas thinking about process stuff is seen as boring. This is unfortunate as it is where you can arguably make the most progress as an investor, if you take the time to do so.
Serious investors however recognise its significance and focus hard on improving what they can. John Hussman made this point in a piece where he talks about the contrast between reactive investors and responsive investors:
A reactive investor tends to reverse existing investment positions only when provoked by pain. Investment positions are sold when they have declined enough to trigger fear or panic. Investment positions are purchased in a rush to “catch” or “ride” them. My impression is that the single best mark of a reactive investor is the tendency to measure investment success by the amount gained or lost on any particular day. In contrast, the investor who responds puts much more emphasis on daily actions than on daily outcomes. That doesn't mean ignoring outcomes, but it means following a specific, well-studied discipline with the expectation that the results will emerge through repeated application.
One of our key goals of Stockopedia PRO is to help people to implement a more structured and effective approach to their investment decision-making. How? By studying the processes and philosophies of the world's greatest investors (always with an eye on outcome bias!), promoting systematic investment screening as a primary search tool, and encouraging quantititative decision-making criteria and investment checklists, on both the buy and sell-side.
Further Reading on the Web