Why the world's greatest investors focus hard on investment process

Sunday, Feb 12 2012 by
Why the worlds greatest investors focus hard on investment process

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...

Outcome Bias 

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…

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UK Value Investor 23rd Feb '12 1 of 1

I couldn't agree more. Sadly most investors follow the 'story' approach to investing where they like to build a story in their heads about the company/industry/economy and then build some mental picture about the future and how things might pan out.

Once they find something with a positive picture (in their heads!) they then look for additional information that backs up their original conclusion.

I'm as guilty as the next person for wanting to follow this approach; it's entirely natural. Unfortunately it's a pretty crummy way to invest for most people and they'd do much better at least framing the story approach within a simple and logical investment process.

Blog: UK Value Investor
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