Process vs. Outcome

“Individual decisions can be badly thought through, and yet be successful, or exceedingly well thought through, but be unsuccessful, because the recognized possibility of failure in fact occurs. But over time, more thoughtful decision-making will lead to better overall results, and more thoughtful decision making can be encouraged by evaluating decisions on how well they were made rather than on outcome” – Robert Rubin

Given Rubin’s recent retirement from Citigroup, I thought this quote was appropriate. Research by Russo and Schoemaker has identified  a common trait amongst successful performers in probabilistic fields: they all emphasize process over outcome. Similarly, investors should try to judge decisions on how they were made instead of on the results they engender.

This is not to say that results don’t matter; obviously they are extremely important in measuring success. That being said, it seems as though many investors  don’t realize that certain positive outcomes, even strung together in successive numbers, are simply part of normal probabilistic distribution. Some believe that because they were able to select winning stocks consecutively, or have 2 consecutive high return years, they possess large amounts of skill. Often, investors fail to examine why they were winners because they are too busy recounting their successes. Remember, “All people are most credulous when they are most happy” – Walter Bagehot. By examining why an investment was (or was not) successful, you can reduce these inherent biases which cloud judgment.

I would recommend looking at fundamentals of valuation rather than stock price. Do not make the mistake of thinking that because the investment worked out, your analysis must have been correct (or vice versa). A perfect example is the internet bubble of the late 90s; many hedge funds believed they had inordinate amounts of skill, when in reality their success was the result of an extreme bull market combined with the human fallacy of hoarding and false expectations. The famous Wall Street adage goes: “Don’t confuse brains with a bull market”. When the bubble burst, they quickly saw that the skill they thought they had was in fact illusionary.

Here are Rubin’s four principles for decision making, which should provide a good basis for thinking about this:

  • The only certainty is that there is no certainty: We need to train ourselves to consider a sufficiently wide range of outcomes.
  • Decisions are a matter of weighing probabilities: We must realize that some high-probability propositions are unattractive, and some low-probability propositions are very attractive on an expected-value basis.
  • Despite uncertainty, we must act: the point here is that we must base the majority of our decisions on imperfect or incomplete information. We must make such decisions based on an intelligent appraisal of available information.
  • Judge decisions not only on results, but also on how they were made: A good process is one that carefully considers price against expected value.
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~ by eboro on July 9, 2010.

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