Category Archives: Investing Process

10 Ways to Improve Your Investment Process – #3. Don’t Focus on the Outcome

The third idea to improve your investment process is to not focus on the outcome. One of the interesting ironies of most activities is that if you focus on the outcome, you’re less likely to achieve it.

A few years ago, Michael Lewis wrote a book called Moneyball. The book tells the story of how Billy Bean built the Oakland A’s into a winning baseball team in spite of having an undersized payroll. Bean worked side by side with a wizkid from Harvard named Paul DeDodesta. Together they used creative thinking and statistical analysis to find undervalued players for the A’s to draft.

For a few years, DePodesta maintained a blog on baseball called “It Might Be Dangerous… You Go First”.  In one memorable post, he wrote about the relationship between process and outcome. He tells the story of an evening in Las Vegas where he observed a game of black jack.  He saw a player draw a seventeen and then, to the surprise of the dealer, ask for a hit, which is a sub-optimal choice.  The player drew a four and won the hand.  The dealer responded, “Nice Hit!”

DePodesta spent the rest of the evening thinking about what he had observed and the relationship between process and outcome.

He concluded that the blackjack player had had a good outcome, but a bad process.

OUTCOME BIAS

It’s easy to fall into the trap of overemphasizing the outcome. After all, results are what matter and people mistakenly believe that a good outcome implies a good process.  That’s a false assumption.

The best hope for a good outcome is a good process.  You should focus on what you can control.  The odds are stacked in favor of the casino, but it doesn’t win every hand.  The casino is profoundly interested in a good outcome, but to achieve it, it maniacally focuses on the PROCESS.

A bad process can also lead to a good outcome, as we saw in the blackjack story. This is, according to DePodesta, the “wolf in sheep’s clothing” that “allows for one-time success but almost always cripples any chance of sustained success.”

FOCUS ON HAVING A GOOD PROCESS

What you should be after is “deserved success” which is a good outcome that results from a good process.  This is where championship sports franchises like the Patriots or the Steelers live, or great investors such as Warren Buffett or Seth Klarman.

Even great achievers experience failure and make mistakes.  Having a good process and getting a bad outcome is a tough reality of operating in areas that involve uncertainty and luck, such as investing.  Nevertheless, focusing on a good process is the best path to sustained success.

It’s tough to admit that you’re lucky when you undeservedly get a good outcome, but it’s critical in order to improve.  According to Paul DePodesta, Billy Beane was successful because he was quick to notice the role of luck “embedded” in a good outcome.    Beane refused to congratulate himself when this happened.

This is what Buffett is getting at when he says that you don’t know who’s swimming naked until the tide goes out. When everything’s going up, there are a lot of folks running around who confuse luck and skill.

You need to guard against this tendency to judge a decision based on the outcome rather than the process of what went into it.

In his 2010 letter to shareholders, Buffett commented on his process for selecting a new chief investment officer.  He wants someone with a good track record, but he’s even more focused on HOW the record was achieved.

Here’s Buffett:

“It’s easy to identify many investment managers with great recent records. But past results, though important, do not suffice when prospective performance is being judged.  How the record has been achieved is crucial…” [emphasis added]

Focus on the process, not the outcome, and you’ll improve your chance of sustained success.

10 Ways to Improve Your Investment Process – #2. Define Your Process

The second idea to improve your investment process – if you have not already done so – is to carefully define it in writing. As investors, by default we all have some type of investment process. Some are good and some are not so good. Some are thoughtfully constructed, some are not.

All of them can be improved through focused effort.

If you haven’t done so already, you should commit your process to writing – not just your general philosophy – but all aspects of your process: your search strategy, research and valuation methods, portfolio management, sell strategy, everything – and then work like crazy to improve it. If you don’t write it down, you can’t study it, tweak it, improve it, and develop it.

WHAT’S YOUR EDGE?

To have a good investment process, you need to answer the question, “What’s my edge?” Investing is highly competitive, and you have to assume that the person on the other side of the trade is intelligent and well-informed.

Michael Mauboussin talks about three types of edge: analytical, psychological and institutional.

ANALYTICAL EDGE

First, let’s consider an analytical edge. Mauboussin explains that you can think of it as the ability to recognize a gap between the fundamentals and expectations. For example, consider horse track betting. The fundamentals are the speed of the horses or the records of the jockeys. The expectations are the odds and the payouts. Having an analytical edge means being able to skillfully handicap the race and see valuation gaps between the fundamentals and expectations.

How do you get an analytical edge? You could focus on one industry or sector, perhaps where you have specialized knowledge or experience. Or, you could focus on complex situations that are hard to understand. Perhaps you could gain an edge by focusing on micro or nano-cap stocks with little or no analyst coverage.

You might want to focus on securities that have shown persistent outperformance, such as special situations. You could look for time arbitrage opportunities where the market is overreacting to recent events and undervaluing a business’s long term prospects.

Don’t underestimate the knowledge and expertise it takes to gain an analytical edge in today’s highly competitive market. The required skill is similar to that of a medical specialist or skilled attorney.

Charlie Munger tells the story of Max Plank traveling around Europe lecturing after he won the Nobel Prize. Apparently he gave the same speech so many times that his chauffer memorized it. To amuse themselves, so the story goes, Plank would have the chauffer occasionally give the speech. During the Q&A that followed, if someone asked a question that the chauffer couldn’t answer, he would retort, “My good man, I’m surprised you would ask such a simple question in a sophisticated European city. I’m going to have my chauffer answer that one.”

We need to avoid chauffer knowledge like the plague when pursuing an analytical edge. Simply regurgitating someone else’s thesis is to have no edge at all.

PSYCHOLOGICAL EDGE

Another type of edge is a psychological edge. One form of having a psychological edge is having the emotional discipline to exploit fear – to step up when others are in a state of panic. Another form of psychological edge is having the patience to wait for obviously attractive opportunities. Also, you might seek an edge in how you run your portfolio by placing large bets on your high-conviction ideas. This is how some of the most successful investors run their portfolios.

Professional poker players only bet in size when the odds are favorable. If you don’t know your edge, you can’t assess when the odds are in your favor. If you invest anyway, you’ll make yourself the patsy and the outcome is much less likely to be positive.

INSTITUTIONAL EDGE

Finally, a word about having an institutional edge.

If your money is managed by a professional money management firm, you will have an edge if they truly put your interests first. How do you know? Do they eat their own cooking? That is, is a substantial part of their net worth in the fund? Are their fees fair? Will they close the fund if it gets too large or are they more interested in harvesting assets? Do they look like a closet index fund or do they have a process that adds real value? Pay close attention and focus your investments with managers who adhere to these principles.

10 Ways to Improve Your Investment Process – #1. Define Your Outcome

The first idea to improve your investment process is define your outcome. You must have a crystal clear idea of what you’re trying to accomplish.

If your target is clear, it helps you define a good process. For example, whether your goal is to beat the S&P500 or achieve an absolute return of 15%, it forces you to think carefully about the type of strategy you’ll need to actually do it. What type of securities will you need to buy?  What are their characteristics?  How will you find them?  What about taxes and transaction costs?

Equally important, it will give you a yardstick to say no to the majority of securities that won’t help you meet your goal.

If you’re target isn’t clear, you may be tempted to rationalize poor results.  Buffett warns about shooting an arrow into a blank canvas and then drawing the bull’s-eye around the implanted arrow.

If don’t have a yardstick, you can’t measure your performance and see if you’re making progress.  Without a yardstick, you can’t see if you’re actually adding value.

Isn’t the purpose of an actively managed fund – to add value?

Finally, I offer a word of caution. You can’t define success as achieving your outcome each and every year. External factors and chance have too much impact on short-term performance.

However, if you can’t reach your outcome over a five-year period, you may be kidding yourself. Your investment process may not be adding any value.

Share via Twitter, Facebook, Email and more.

10 Ways to Improve Your Investment Process – Introduction

You would not be reading this if you did not want to improve your investing results. Provided that you already have a rational investing philosophy, the key to improving your results lies in improving your investment process.

I have been investing for over twenty years. Like you, I want results.  If over time I can’t beat the market averages, what’s the point? I’d rather buy an index fund and forget about it.

The good news is there’s plenty of evidence that this goal is achievable – not easy, but achievable.

One thing I have learned in studying the great investors is that they all have a great investment process that drives everything they do.

There’s no secret formula. No valuation algorithms hidden away in Omaha. No short cuts. You need to create a solid investment process based on a rational investing philosophy that has been proven to generate market-beating results.

The outcome of some activities is entirely a function of skill.  Examples include chess and the 100-meter dash. Other activities, such as rock-paper-scissors or roulette, are based entirely on luck.

Investing is somewhere in the middle. Its outcome is a function of both skill and luck. That is why it is difficult to identify if an investor has skill. A know-nothing investor can be lucky and a skilled investor can have periods of under-performance.

Serious investors recognize this reality and focus on what they can control. They focus on their investment process knowing that – over time – real skill will reveal itself in superior long-term performance.

This leads us to a definition of process.

A process is an organized group of activities designed to constantly improve skill and increase its role in an outcome, thereby minimizing – to the degree possible – the role of luck.

AN EXAMPLE FROM SPORTS

You can learn about the power of process by studying football coach Nick Saban. He won college BCS National Championships at LSU in 2003 and at Alabama in 2010.

Saban’s success comes down to an almost maniacal focus on getting better in all aspects of the game – an effort he simply calls The Process.

Saban’s process includes recruiting, conditioning, practicing, work ethic, strategy, and organizational structure.  His recruiting process alone has five distinct steps.  The process begins as soon as the season ends and it continues year round.

Saban’s process is an effort to squeeze chance from the equation and increase the odds of winning.

Saban talks about how you can’t skip steps.  You can’t get from point A to point Z without passing through point B and that if you skip a step, you won’t achieve your desired outcome.  Saban talks about finishing.

Saban’s process is not about genius, better information, or even better athletes.  It’s about sweating the details.  It’s about working harder and smarter and looking to exploit the weaknesses of your opponents.

In this series of blog posts, I’d like to share ten ideas to improve your investment process. I’ve learned these ideas from my own experience and from studying the great investors.

PASSION

Before laying out the ten ways to improve your investment process, I want to say a word about passion. Passion is essential if you want to be a great investor. You need to love what you’re doing.

If you choose to pursue becoming a great investor, you will spend a great deal of your time reading and thinking. Many days your work will not appear to be fruitful. Only occasionally will you find a truly worthwhile idea. Then, if the idea checks out and you make a purchase, you will need to patiently wait for your thesis to play out. This may take several years.

Unless you love what you’re doing and can derive pleasure from the process of learning and mastering your craft, it’s unlikely that you will persevere. This requires passion.

New Audio: Ten Ways to Improve Your Investment Process – #6. Improve Your Risk Management

If you want to be a successful investor, you need a great investing process. Ironically, focusing on the outcome can lead to poor results.

This is part four of an eleven-part audio series on improving your investment process. It is based on a presentation I gave to the CFA Society of Columbus on May 19, 2011 at The Ohio State University.

#6. Improve Your Risk Management (audio)

PDF of presentation slides

 

Previous audio recordings in this series:

Ten Ways to Improve Your Investment Process – Introduction

#1. Know Your Outcome

#2. Define Your Investment Process

#3. Don’t Focus on the Outcome

#4. Use Checklists

#5. Improve Your Search Strategy

 

New Audio: Ten Ways to Improve Your Investment Process – #5. Improve Your Search Strategy

If you want to be a successful investor, you need a great investing process. Ironically, focusing on the outcome can lead to poor results.

This is part four of an eleven-part audio series on improving your investment process. It is based on a presentation I gave to the CFA Society of Columbus on May 19, 2011 at The Ohio State University.

#5. Improve Your Search Strategy (audio)

PDF of presentation slides

 

Previous audio recordings in this series:

Ten Ways to Improve Your Investment Process – Introduction

#1. Know Your Outcome

#2. Define Your Investment Process

#3. Don’t Focus on the Outcome

#4. Use Checklists

 

New Audio: Ten Ways to Improve Your Investment Process – #3. Don’t Focus on the Outcome

If you want to be a successful investor, you need a great investing process. Ironically, focusing on the outcome can lead to poor results.

This is part three of an eleven-part audio series on improving your investment process. It is based on a presentation I gave to the CFA Society of Columbus on May 19, 2011 at The Ohio State University.

#3. Don’t Focus on the Outcome (audio)

PDF of presentation slides

 

Previous audio recordings in this series:

Ten Ways to Improve Your Investment Process – Introduction

#1. Know Your Outcome

#2. Define Your Investment Process

 

New Audio: Ten Ways to Improve Your Investment Process – #2. Define Your Process

If you want to be a successful investor, you need a great investing process.

This is part three of an eleven-part audio series on improving your investment process. It is based on a presentation I gave to the CFA Society of Columbus on May 19, 2011 at The Ohio State University.

#2. Define Your Investment Process (audio)

PDF of presentation slides

 

Previous audio recordings in this series:

Ten Ways to Improve Your Investment Process – Introduction

#1. Know Your Outcome

 

New Audio: Ten Ways to Improve Your Investment Process – #1. Know Your Outcome

If you want to be a successful investor, you need a great investing process.

This is part two of an eleven-part audio series on improving your investment process. It is based on a presentation I gave to the CFA Society of Columbus on May 19, 2011 at The Ohio State University.

Here is part 2:

#1. Know Your Outcome (audio)

PDF of presentation slides

 

Previous audio presentations in this series:

Ten Ways to Improve Your Investment Process – Introduction (Audio File)

More on Saban’s World-Class Football Process: Many Lessons for Investors

For those following my audio series on how to improve your investment process, I’m posting the following articles on Nick Saban’s football process. I think they contain numerous lessons on how to think about and construct a great investment process and this will let you do a deeper dive, if interested.

For Nick Saban, The Process Finally Has an End in Sight | Bleacher Report

Archibald: Saban ‘process’ could change Birmingham | al.com

The Process: Saban’s blueprint has a name, but what exactly is it? | al.com

The Nick Saban method of recruiting – ESPN