As an investor, do you tend to attribute skill to good outcomes and bad luck to bad outcomes, without fully considering your investment process? If so, you’re not alone. It’s a common mistake. But recent market volatility underlines the need to develop a really solid investment process – and let the outcome look after itself.
The tendency to judge a decision by its outcome rather than the quality of the decision-making process is known as outcome bias. Investors are predisposed to fall victim to this bias because i) outcomes are objectively easier to measure than processes; ii) it takes conscious mental effort when assessing a process to not be tainted by the outcome; and iii) investment outcomes are returns, and returns are ultimately what matter.
Take a look at the above matrix—most, if not all, investors would prefer to be on the left hand side of the matrix rather than the right hand side. Yet to consistently achieve good outcomes, it is clear that a good process is required.
Developing an investment process should be the second priority for any prospective investor, whether they intend to invest their funds directly or through an investment manager. A good investment process is one that is built on the foundations of the investor’s investment philosophy (the first priority). If an investment philosophy espouses preservation of capital and owning only high quality businesses, then the process needs to be designed to identify businesses that generate high returns on capital and have sustainable competitive advantages or economic moats, which can be bought at a discount to intrinsic value.
Unfortunately, having a good process in place is only half the battle; the other half is sticking to it. Here, investors are challenged on two fronts. Firstly, even the best process can occasionally produce an outcome in the top right quadrant of the matrix. In these situations, it is important to remember that even a process which produces 99 per cent good outcomes will still produce a bad outcome 1 per cent of the time, and not start second-guessing the process. The other challenge is to not deviate from or make exceptions to the process, for example by overpaying for a great quality business out of fear of missing out. This dilutes a good process (often by stealth) and soon the investor may be unwittingly celebrating dumb luck or brushing off poetic justice.
In recent weeks, volatility has returned to global equity markets after an extended period of complacency. In this environment, investors’ ability to separate process from outcome has become all the more important, and will be a determining factor of how well they can navigate the uncertain times ahead.