Want to be a successful long-term investor? If yes, then you should focus on the process, not the outcomes, when making your investment decisions.
Michael Mauboussin makes that case in chapter one of his 2013 book, "More Than You Know: Finding Financial Wisdom in Unconventional Places."
Not surprisingly, many of us focus on outcomes without considering the process that led to the result. Equally unsurprising is that many of us have the notion that good outcomes were the result of good processes and bad outcomes arose out of bad processes.
What’s missing in those notions is the element of probability, a common feature in fields such as investing, sports team management and sports betting. Mauboussin cited Jay Russo and Paul Schoemaker to argue that because of probabilities, bad processes sometimes lead to good outcomes, and vice-versa.
In the long run, however, process will dominate outcome. That’s why casinos make money and gamblers collectively lose money.
The author explained that the goal of an investment process is to identify gaps between a company’s stock price and its expected value. What is expected value? That’s what brings probability into the mix; it is “the weighted-average value for a distribution of possible outcomes.” Think of a bell curve, with the highest probabilities in the center and the lower probabilities in the tails on either side.
To calculate expected value, you multiply the payoff, or stock price, for a given outcome by the probability that the outcome occurs. Turning to another source, Investopedia defines expected return this way: “The expected return is the profit or loss an investor anticipates on an investment that has known or anticipated rates of return (RoR).”
It offered this example:
- An investment has a 50% chance of increasing 20%.
- It has a 50% chance of losing 10%.
- The expected return is 5% (50% x 20% + 50% x -10% = 5%).
Mauboussin went on to state, “Perhaps the single greatest error in the investment business is a failure to distinguish between the knowledge of a company’s fundamentals and the expectations implied by the market price.”
As I understand the author’s thinking (and I may be wrong), investors are dealing with three factors: fundamental knowledge about a company’s earnings, cash flow and other fundamentals; the probabilities that a stock will reach a certain price; and the stock’s current or market price. A good investment process would logically include all three of these elements.
That assessment appears to be borne out with this observation by Mauboussin: “A thoughtful investment process contemplates both probability and payoffs and carefully considers where the consensus—as revealed by a price—may be wrong. Even though there are also some important features that make investing different than, say, a casino or the track, the basic idea is the same: you want the positive expected value on your side.”
He then went on to list four principles of decision-making, as explained by former Treasury Secretary Robert Rubin (University of Pennsylvania commencement address in 1999):
- “The only certainty is that there is no certainty.” In other words, uncertainty means the underlying distribution of outcomes is undefined—we cannot establish the probability of any specific outcome. On the other hand, with risk, we do know what the distribution is. One manifestation of uncertainty is a black swan event, an unexpected but impactful event (depression, wars, energy crisis, terrorist attack). As Mauboussin noted, many crash-and-burn hedge fund failures were the result of committing too much capital to an investment because of overconfidence.
- “Decisions are a matter of weighing probabilities." According to the author, we need to balance the probability of an outcome (frequency) with the outcome’s payoff (its size). For example, you might buy 10 stock options for $1 each; nine of them expire worthless, but the tenth jumps to $25. That’s a low frequency, but high payoff scenario. That’s why he argued that probabilities alone are meaningless when payoffs are skewed.
- “Despite uncertainty, we must act.” By this, Rubin was telling us we rarely have all the information we need to make a decision. Instead, we make choices based on a thoughtful assessment of the limited information that is available to us. However, there is an interesting catch-22 here: According to Russo and Schoemaker, additional information often makes the decision-making process more confusing.
- “Judge decisions not only on results, but also on how they were made.” This means an investor will carefully consider the price against expected value. Further, he said, “Investors can improve their process through quality feedback and ongoing learning.”
Mauboussin then tells the story of one of his students, the head of a successful hedge fund. The former student had instructed analysts in his firm to stop using target prices, and instead to provide expected values. The new approach forced discussions about payoffs and probabilities, and that in turn reduced the risk of putting too much emphasis on any one scenario. Further, if analysts use an expected value analysis, they’re forced to consider potentially unfavorable outcomes.
Conclusion
In chapter one of "More Than You Know," Mauboussin has laid out a case for focusing on processes rather than outcomes. He wants investors to be more like casinos and less like gamblers because casinos use processes that allow them to know the probabilities of different outcomes.
The anecdote about his former student illustrates how it is helpful to replace target prices with expected values, i.e., the range of possible outcomes. By knowing the probabilities of each potential outcome, it pushes investors toward more-likely outcomes rather than less-likely outcomes.
By focusing on processes, not outcomes, investors bring probabilities into their decision making, and that should lead to better long-term results.
Read more here:
- More Than You Know: Building on Charlie Munger’s Intellectual Legacy
- Just One Thing: Attempting to Beat Time
- Just One Thing: 'Skill and Information Are Your Remedies'
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