Outcomes Versus Reasons

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Grahamites
Apr 22, 2015
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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 (BRK.A, Financial)(BRK.B, Financial) 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, Financial) and Fairfax (FFH, Financial) 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 (JCP, Financial) and Donald Yacktman in Avon (AVP, Financial) 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 dont 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.

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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.