Process versus Outcome in Investing
It is Columbus Day — not the "observed" day where government agencies and bond traders take the day off, but the real one. Who better to remind us than Art Cashin:
On this day in 1492, Christopher Columbus landed at the Bahamas, believing that he had landed in the islands off Japan. And so history is indebted to a man with a flawed theory who set out on a venture where he didn’t know where he was going, suffered sharp losses on the way and didn’t know where he was when he got there. And he did it all on borrowed money.
The world only cared about the results. It reminds us of investors.
Why Process is Important
Looking only at investment outcomes leads many into a trap they do not understand — getting Fooled by Randomness. With thousands of investment managers, gurus, mutual funds, and ETF’s there will always be a choice that represents a hot hand. Does this really predict future investment success?
Investors chasing performance get returns of about 1/2 the market average. Two prominent commentators describe the significance of process.
Bill Miller, the stellar manager of the Legg Mason Value Trust made the point clearly at an investor conference, quoting former Treasury Secretary Robert Rubin:
Any individual decision can be badly thought through, and yet be
successful, or exceedingly well thought through but be unsuccessful because the recognized postulate for failure in fact occurs. But over time more thoughtful decision-making will lead to better overall results, and more thoughtful decision-making could be encouraged by evaluating decisions on how well they were made rather than on the outcome.
At the start of this year, Miller gave his opinion about the markets: The stock market is still cheap.
Barry Ritholtz recently wrote a thoughtful comment with the same theme:
Consider the long list of folks who have been right in their analysis,
but wrong in the timing of the market reaction to this; Then think
about some of the weaker bullish arguments — there have been an
enormous run of absurd arguments, false theories, ridiculous analyses.
Regardless, these get overlooked by many as the markets continued
upwards. Right answer, wrong process.
Ritholtz is noted for his bearish perspective on the U.S. economy and markets.
Anyone can look at a table to check out recent results. Few can evaluate the investment process of pundits and fund managers. They all sound good. As one investor told me, "I understand what you are saying about process, but I cannot use that. I only have results to go by." The irony is that this may be the worst possible method.
While we have been enjoying a very good year, we fully appreciate this investor dilemma. It is difficult to persuade clients about process when you are in the middle of a "cold" streak. It takes confidence in one’s process to maintain discipline in the face of adversity.
Cashin notes that the bearish advisers of Ferdinand and Isabella warned that Columbus would run out of fresh water before reaching Japan or China. They were correct. He would have. It was a stroke of fortune that he reached the New World and more water.
It is up to each person to evaluate reasoning and process as well as results.