Investing is a probabilistic exercise, where we as investors have to deal with imperfect information and also an uncertain future. Most people do not realise that investing involves dealing with a myriad of risks, and that analysis, luck, and a good process all play a role in producing positive results.
One big mistake which many investors make constantly, though, is assuming that the outcomes alone justify the decision made, even though the outcome could have been influenced by purely random factors such as luck. Let us look more closely at both process and outcomes.
What is an investment process
It is useful to first define what an investment process is. A good investment process should consist of a set of clear guidelines and rules with which we rely on to select and curate our portfolio. We would dictate the traits we are looking for in good investments while clearly spelling out the characteristics in an investment we would avoid.
Note that the investment process needs to be improved upon over time and is not cast in stone – a novice investor obviously would not have as robust a process as a veteran investor, but the key here is to continually refine our investment process as we gain investing experience and make mistakes.
What is an investment outcome
Outcomes can either be good or bad, but they may result from a variety of different factors, some of which may not have been anticipated. I find it useful to illustrate my point on process versus outcomes using a table, as shown below:
Outcome vs process
We can see from the above that a bad process may sometimes result in a good outcome – but this type of good outcome should be rightly attributed to “dumb luck” rather than a well-reasoned analysis. On the other hand, a good process may sometimes yield a bad outcome – this is a “bad break”. To illustrate these two points, a bad process involving the selection of a company with very high amounts of debt may turn out well if an acquirer decides to buy out the debt-laden company at a premium, yielding a good capital gain for the investor. The process itself to select the company was flawed as the company may have been sinking under the weight of its debt load, but a lucky event – the acquisition – occurred which redeemed the investor. If the investor focused only on the outcome, he may wrongly conclude that his decision was correct, even though it was severely flawed.
A good process may sometimes end up with a poor outcome if something unexpected occurs. For example, an investor may buy into a strong, solid, and well-run company headed by a capable and competent CEO with a good track record. However, a few months later, the CEO suddenly passes away from a heart attack, and the company is left scrambling to find a suitable successor. The passing of the CEO may cause the value of the company to decline permanently and the investor may suffer a loss as a result.
The lesson here is to not judge the quality of an investment decision by its outcome alone. It is important to also note the process involved in the decision-making to assess the quality of the decision.
Click here now for your FREE subscription to Take Stock Singapore, The Motley Fool’s free investing newsletter. Written by David Kuo, Take Stock Singapore tells you exactly what’s happening in today’s markets, and shows how you can GROW your wealth in the years ahead.
The Motley Fool’s purpose is to help the world invest, better. Like us on Facebook to keep up-to-date with our latest news and articles.
The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.