Process versus results

Every few months, I seem to return to this subject because it's so important to successful investing--there is a world of different between investment process and investment results, especially in the short term!

Results are what you get, process is how you get it. Confusing the two leads to all kinds of investment mistakes. Why?

The reason why, to over-simplify, is randomness. The world is so complex that you can't possibly know all the variables that can impact a particular result. You may have a bad results, but a good process. Or, you may have a bad process, but get good results in the short term.

If you have the right process, but watch short term results too closely, you may give up before the big payday comes. If you have the wrong process, but get lucky and have a good result, you may continue to implement the wrong process leading to terrible long term results.

Let me give a concrete example because the subject probably seems way too abstract so far.

Suppose I make you an offer: would you pay me $200 for a one in six change of winning $1,000? I'll roll a die, if it comes up 1 I'll pay you $1,000, if it comes up 2-6, I keep the $200 you pay me to play. Sound like a good offer?

No, it's not. You have a 1 in 6 chance of getting $1,000, so you have a 16.67% chance of winning. Multiply the probability, 16.67% times the payout, $1,000, and you come up with the expected value: $166.67. Because you have to pay $200 to play and the expected value is less, you shouldn't play.

Let's suppose you haven't done the math above, and you decide to play. Suppose you win. Winning will be psychologically exhilarating, releasing all kinds of feel-good endorphins in your brain. This "high" feeling will encourage you to play again. But, the more you play, the more likely you are to lose. The odds and payout are against you.

The good result, winning luckily the first time, may encourage you to continue using a bad process, playing a game with a negative expected value.

Let's suppose I tell you it costs $100, instead of $200, to play the game. Would you play now? Because the expected value is more than the price to play, you should play.

Let's suppose you decide to play, but you lose the first time. Let's suppose you play again, and lose again. The more you play and lose, the more you feel like you should quit the game. The price of playing over and over again and losing takes it's toll on you, you begin to get angry, frustrated, and want to quit. Should you?

No. The odds and payout are in your favor, so you should keep playing. Just because the outcomes look bad over the short term, doesn't mean they are bad over the long run. In the long run, you'll win if you keep playing, but that takes a lot of discipline.

I think about process and results all the time. Sometimes I make a good process investment and it doesn't do well. I beat myself up for being so stupid, but that doesn't mean my process is bad or that my long run results will be poor. If the odds and payout are in my favor, I'll win if I keep implementing the right process. Sometimes I make a bad process investment and it does well. This encourages me to repeat the process, especially if I don't examine whether I was lucky or good. But, implementing the bad process will eventually catch up with me, the odds always do, and I'll lose in the long run.

Focusing on process is vitally important in any situation where randomness plays a part. If you focus too much on short term results instead of the process, you'll make costly and repeated mistakes.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.