Paul DePodesta, a former baseball executive and one of the protagonists in Michael Lewis’s Moneyball, tells about playing blackjack in Las Vegas when a guy to his right, sitting on a seventeen, asks for a hit. Everyone at the table stops, and even the dealer asks if he is sure. The player nods yes, and the dealer, of course, produces a four. What did the dealer say? “Nice hit.” Yeah, great hit. That’s just the way you want people to bet – if you work for a casino.
This anecdote draws attention to one of the most fundamental concepts in investing: “process versus outcome”. In too many cases, investors dwell solely on outcomes without appropriate consideration of the process that lead to them. The focus on results is to some degree understandable. Results — the bottom line — are what ultimately matter. And results are typically easier to assess and more objective than evaluating processes.
The man who was the weaker bridge player of the husband-and-wife team bid a grand slam. In the end he said very triumphantly to his wife ‘I saw you making faces at me all the time, but you notice I not only bid this grand slam but I made it. What can you say about that?’ And his wife replied very dourly, ‘If you had played it right you would have lost it.’”
“Individual decisions can be badly thought through, and yet be successful, or exceedingly well thought through, but be unsuccessful. 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, Harvard Commencement Address, 2001
“It’s not that results don’t matter. They do of course. But judging solely on results is a serious deterrent to taking into account factors that may be necessary to making the right decision. Simply put, the way decisions are evaluated affects the way decisions are made” – Robert Rubin
“Any time you make a bet with the best of it, where the odds are in your favor, you have earned something on that bet, whether you actually win or lose the bet. By the same token, when you make a bet with the worst of it, where the odds are not in your favor, you have lost something, whether you actually win or lose the bet. – David Sklansky, The Theory of Poker
Judging an “outcome” in the absence of knowing it’s “process” is akin to judging “price” in the absence of “value”. Or judging “returns” in the absence of the “risk” undertaken. Such unaccompanied judgments should mean little. Process-biased value investors do not ascribe to “the ends may justify the means”. They believe instead in: “the ends should be justified by the means” – Husain Kothari, “Of Processes & Outcomes”
People often make the critical mistake of assuming that good outcomes are the result of a good process and that bad outcomes imply a bad process. In contrast, the best long term performers in any probabilistic field — such as investing, sports-team management, and pari-mutuel betting — all emphasize process over outcome.
Jay Russo and Paul Schoemaker illustrate the process-versus-outcome message with a simple two-by- two matrix below. Their point is that because of probabilities, good decisions will sometimes lead to bad outcomes, and bad decisions will sometimes lead to good outcomes — as the hit-on-seventeen story above illustrates. Over the long haul, however, process dominates outcome. That’s why a casino — “the house” — makes money over time, which they of course do only because…casino visitors lose over time.
Value Investors seek “Deserved Success”. This is where the Tiger Woods, the Tendulkars, the Buffetts of the world live. A “Bad Break” is a tough reality of operating in areas involving uncertainty and luck, such as investing. “Dumb Luck” is dangerously beguiling so beware! Its tough to admit that you were lucky when you undeservedly get a good outcome. It is vital however to recognize the “embedded” luck element and refrain from self-flatter. This in itself is dangerous and yet easy to comprehend. The greater danger lies in the positive outcome validating the bad process.
Remember the guy who won big at the horse-races on his first visit. He deluded himself into believing that he was skilled and his process was good. He kept playing for the rest of his life until he went broke. It is then relatively fortunate to fall early into the Bad Process -> Bad Outcome quadrant in the above matrix. And conversely unfortunate to experience a Bad Process -> Good Outcome event which leads to inevitably to “Poetic Justice” and considerable pain.
Conclusion: Adopt a process bias. Guard yourself against judgments based on outcomes in the absence of the investigating the processes that led to producing them. To quote Rubin, “the way decisions are evaluated affects the way decisions are made”.
August 28th, 2012