One of my readers, Parker, pointed out in his comment on my post about Mistakes in Investing, that “one of the trickiest things about investing is determining when a bad result stems from a mistake (an oversight or error in process), or just from inevitable bad luck.” I felt that it was such an important distinction I would post about it.

As a basis for today’s post, I will highlight some points that James Montier made in an article titled, Process Not Outcome in Gambling, Sports and Investment!, that I read in his Postcards from the Edge.

“Psychologists have long documented a tendency known as outcome bias. That is the habit of judging a decision differently depending upon its outcome,” says Montier. He sets out a chart that breaks down the results from Process and outcome that looks like this:

For obvious reasons we would all like every decision to be in the upper left, that is Good Process, Good Outcome, because it yields a Deserved Success. But we won’t. Sometimes we venture into the territory of the bottom left. Dumb Luck. And given the outcome bias we will want to reinterpret the decision making process because the result was good. However, Montier says, that if you can’t make this distinction, “the bad process will continue and the good outcome that occurred once will elude you in the future.”

Let me step back to Parker’s comment again, “It is very possible to make an investment that is fully rational, fits your portfolio, has a high expected return, and still loses money due to factors outside of your control. On the flip side, it is also possible to make money playing Lotto or engaging in other irrational activities.” I would argue that the outcome bias is so strong that we often confuse the two ideas of process and outcome, we certainly do in the film business.

In fact holding people accountable for outcomes, according to a meta study conducted by Lerner and Tetlock, has some undesirable characteristics, including:

“i) increase ambiguity aversion (increased preference for alternatives with less ambiguity
despite equal risk).
ii) increase the collection and use of all information (both useful and useless).
iii) increase the preference for compromise options, and increase the selection of products
with average features on all measures over a product with mixed features (i.e. average on four
traits, preferred to good on two and bad on two).
iv) increase the degree of loss aversion.”

Montier sums up, “During periods of underperformance … the pressure always builds to change your process. However, a sound process is capable of generating poor results, just
as a bad process can generate good results.”

But how can we be clear that the decision was sound and that the outcome was unfortunate result in such a case? I think one needs to hold tight to principles that have worked over time, and that have evidence that supports the success of these methods. Much has been documented in the Value Investing world about out-performance over time of buying low price to book small cap stocks and Net Net Stocks discounted by Graham’s Margin of Safety of 33%. That is a good place to start developing a strategy.

But it is also important to put a frame around your decisions. Assuming you are following Value Investing Principles that have worked, how long do you hold a loser? How long before you admit that the result was poor, even though the decision may have been good?

As I often do, I will return to Graham. He discussed a time frame for investments being an appreciation of 50% ( if the decision results in a good outcome) or to sell it in two years, no matter what, (if the decision results in a less favorable outcome). That is certainly a good place to start. Most investors don’t have the patience these days. The average investor holds a stock just 9 months right now. Two years may seem like an eternity to realize a return on capital. But evidence also bears this out. That these kinds of investments can take time to realize a return.

Do you have any thoughts on this subject? Is there a better way of determining if you have outcome bias? Or is there a better way of determing how long to hold unprofitable stocks? If so please post in the comments or email me at chroma at chromainvesting dot com.

2 Responses to “Good Decisions, Bad Outcomes in Investing”

1. Parker Bohn
   February 18th, 2010 @ 6:43 am

   Thanks for the excellent response to my response.

   I’ve been doing a review of my investment process and results, and I’ve found some interesting things. I’ll post more when I have time.

2. chroma
   February 18th, 2010 @ 7:48 am

   Parker,
   Thanks for the feedback. I think the point of a blog is that we can share ideas that push us further than one person may travel on their own. Looking forward to your contribution.

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