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Outcomes Versus Reasons

One of the things that I find absolutely fascinating in the investing world is that most investors judge whether an investment decision was right or wrong solely by the outcome. If the outcome is favorable then the decision was a great one and if the outcome is adverse, then the decision was a poor one. What is often neglected is the fact that in life and investing, we are often “right for the wrong reason” or “wrong for the right reason.”

Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) have repeatedly emphasized the importance of being rational in investing. I think, in order for us to be rational, it is imperative that we separate the result from the decision, even though it seems counterintuitive to do so.

If we think about it, there are only five possible combinations of results and reasons.

1. Right result for the right reason – skill only, no luck or very little luck needed.

Most of Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio)’s investments fall into this category, obviously. What I want to point out is that investors with less skill than Buffett and Munger but with great temperament also often make investments in this category. Mohnish Pabrai (Trades, Portfolio) is a perfect example.

2. Right result for the wrong reason – undeserved lucky.

This category is where we should pay special attention because this is where most investors falter. Investors who made money in the tech bubble, in the housing bubble, in stocks of companies whose fundamentals in no way justify the valuation or just in an extended rising market, often think that they are right for the right reasons. But in reality they are not. I hasten to point out that being aggressive in the above mentioned situations will be greatly rewarded as long as the music continues. The reinforcing feedback loop will make one feel he or she is the greatest investor in the world until the balancing feedback loop kicks in and turns things the other way around.

I can guarantee that all of us will make investments that fall into this category, especially in our early investment career. It may be provocative to say so, but I personally think even some of Warren Buffett (Trades, Portfolio)’s early cigar butts investments are examples of this category, especially the Dempster Mill and Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) investments. The most important and difficult thing to do is to admit that I am only lucky, which few of us are willing to do.

3. Wrong result for the right reason – skill but unlucky.

This is the unfortunate but more-frequent-than-you-think category. A prime example is the years leading up to the tech bubble. Of course, the end result is a pleasant one but for many years, the investment decisions being made by almost all the genuine value investors during that period of time could not look more wrong.

The following statements from Seth Klarman (Trades, Portfolio)’s 1999 letter to investors sum it up really well: "We underperformed in 1999 not because we abandoned our strict investment criteria but because we adhered to them, not because we ignored fundamental analysis but because we practiced it, not because we shunned value but because we sought it, and not because we speculated but because we refused to do so. In sum, and very ironically, we got hurt not speculating in the U.S. stock market."

You can also be right in your individual stock analysis and the most probable outcome failed to happen. I would argue that investors who bet on the merger between Blackberry (BBRY) and Fairfax (FFH) looked wrong but for the right reasons. The more probable outcome failed to happen.

4. Wrong result for the wrong reason – deserved unlucky.

Speculators, herd followers and those who often fall for the so-called “value traps” may very often make investment decisions that fit this category. I just read a story about a day trader who started with $100,000 many years ago and left with a few thousands. The commissions alone almost killed his investment results, let alone the poor performance of way too many stocks he picked.

Investors who have unsound investment philosophies are especially prone to make this mistake. What comes to mind are those who base their investment decisions mostly on the P/E and P/B ratios and such. A stock is not cheap because it has P/E ratio of 8 and P/B ratio below 1. A stock is not cheap because the assets value is higher than the enterprise value when there is no way that the value of the assets can be unlocked.

Investors who blindly copied other investors’ ideas without knowing why are also more likely to make this mistake. Those who followed Buffett in Tesco, Bill Ackman (Trades, Portfolio) in JCPenney (NYSE:JCP) and Donald Yacktman in Avon (NYSE:AVP) have swallowed some bitter pills.

5. Whether the result or the reason is right or wrong cannot be reasonably assessed – a clear sign of out of circle of competency.

The investing world is full of people who are often “right for the wrong reason” or “wrong for the wrong reason” but think they are “right for the right reason” or “wrong for the right reason.” Human nature being what it is, there is nothing evil about it. But to achieve satisfactory returns and superior returns, especially superior returns, one has to improve his batting average in the “right for the right reason” or “wrong for the right reason” camp.

Great, but how can we do that? There are many ways to achieve a better batting average but in my opinion, the following habits are absolutely essential.

  1. You have to incorporate probabilistic thinking. In investing, very few things have only one possible outcome. There is a range of outcomes, and you should be able to assess which of them is the most likely one.
  2. You have to keep track of your investment thesis, and your thesis should be very clear and detailed.
  3. You have to categorize each of your investment decisions into the categories mentioned above.
  4. You can start collecting examples of each category and learn from them. It can be from you own personal experiences, and it can be successes or mistakes of other investors.

You don’t have to do all those things, but at least you have to be cognizant of the reality that, in the long run, only right reasons can lead to great results consistently. In the short run, we must stick to the value discipline when good decisions may look like mistakes temporarily. This may be something we have to do presently.

About the author:

A global value investor constantly seeking to acquire worldly wisdom. My investment philosophy has been inspired by Warren Buffett, Charlie Munger, Howard Marks, Chuck Akre, Li Lu, Zhang Lei and Peter Lynch.

Rating: 5.0/5 (14 votes)



Jean-Francois Nobert
Jean-Francois Nobert - 3 years ago    Report SPAM

This is a great article.

The Science of Hitting
The Science of Hitting - 3 years ago    Report SPAM

Great article Grahamites. Keeping track of a detailed initial investment thesis is one of the hardest things to do IMO unless you write in down; so easy to trick yourself into beliving / "knowing" that you knew something all along that you've actually picked up over time. Keep up the good work!

Thomas Macpherson
Thomas Macpherson premium member - 3 years ago

Hi Grahamites. Fantastic article. We agree completely with what you've laid out here. In our annual report we use a 2x2 outlined by Maubisson and mentioned in Science's article. Each of our investments over the last ten years are placed in one of the boxes. Every year we write about one of the good process/good results and one of the bad process/bad results. In addition every quarter we review our investment thesis for each holding and see how we are tracking against our predictions. If you don't have intellectual honesty in this business you will come to grief very, very quickly. Thanks again for a great post. Best. - Tom

Scott Ryan Anderson
Scott Ryan Anderson - 3 years ago    Report SPAM

Enjoyed the article. Glad you brought up JCP.

Probabilistic thinking on that company is that it goes the way of a Woolworth, Gimbels, Radio Shack... There is simply no reason for the co to exist. This is a company, the ambition of which has been relegated to "not going bankrupt". Who wants to invest in a company with the potential to merely survive in a coma on life support? The name J.C. Penney or JCP itself has a stigma outside of the 70+ crowd and there is no place for it in the capitalist market.

I'm not sure exactly how you define "value trap" but I think that one would qualify.

Marcial - 3 years ago    Report SPAM

Excellent article.The way of presentation is really appreciable.I like alot.Looking forward to your other great post.All the best.

Grahamites premium member - 3 years ago

ecotycoon - Thanks for the nice words:)

Grahamites premium member - 3 years ago

Science - Thanks for the nice words. You are doing a great job putting out your thesis here and keeping track of it. I have no doubt that habit has helped you you to become a much better investor. Keep up the good work as well:)

Grahamites premium member - 3 years ago

Tom - Thanks so much for the compliments. That's a great process you have at Nintai. I admire you because very very few people can do that:) It could be a humbling process if we are truly honest to ourselves from time to time but the benefit tremendous.

LydiaLoftis - 2 years ago    Report SPAM

This article point out the way in which the two important things decision and reasons are connected. This is a creative article and the author executed the ideas in a good manner. Here we have a clear cut information about this.


BuyDissertation - 2 years ago    Report SPAM

You have made some valid arguments in this article. The thought that you have portrayed in this article is relevant and I thoroughly enjoy the way you present this valuable information.


Volodymyrlev228 - 1 year ago    Report SPAM

This one is great! I will use this material for my educational blog

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