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.

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My evolving investment approach

It’s interesting to note how my investment research process has changed over the years.

From the time I first read about value investing in 1995 up until 1998, my focus was almost exclusively on the numbers. Basically, I picked investments based on my assessment of the value of each business with a much lower emphasis on other factors (management, economics, product life cycles, etc.). I crunched the numbers and bought if something looked remarkably cheap.

From 1998 until 2001, my focus began to include a more thorough analysis of business economics. Here, my aim was to gain an in-depth understanding of the competitive advantages of each business and to what degree they were sustainable. This effort was much more qualitative than quantitative.

In 2001, I started to include a much more thorough analysis of management, too. For this, I looked at management’s tenure, their competence in the field, their compensation structure, their ownership of the business, the way that they talked to shareholders, etc. This, too, was a more qualitative effort.

What I’ve found is that you can never stop learning in this field (or in any other for that matter). Every year, I bring new elements into my analysis. Every year, I read books or articles that lead me to dig deeper into certain aspects of each business.

Although my general approach has remained the same–I look to buy underlying businesses, not stocks, and I try to buy them significantly below their assessed value–I continue to add more and more layers of analysis and experience on top.

I keep very good records of the investments I’ve looked at over time, both the ones I invest in and the ones I don’t. This has allowed me to review my past decisions and prevent sins of both omission (not investing) and commission (investing when I shouldn’t have) going forward.

I love my job, and I love learning more and more each year such that I can improve my expertise and, more importantly, my results going forward. And, as Charlie Munger and Warren Buffett have amply demonstrated, that’s a great way to build wealth and enjoy life.

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.

Process versus results

One of the hardest things to do when investing is to keep my focus on process instead of results.

Does that mean that results are unimportant? No. But, it does mean that an over-emphasis on short term results can prevent me from achieving truly unique investing performance.

I find that an analogy, here, helps me grasp this difference. I believe that being honest is necessary to achieving happiness. But, being honest at any particular time does not mean that happiness will instantaneously follow. Honesty is a virtue–like all others–that yields results over the fullness of time.

It seems that everyone has heard of an unscrupulous salesperson that has made a fortune while being less than honest. Such salespeople may do very well in the short term, but over the long term they’re going to pay the price for treating others poorly. It may take decades for this price to be paid, but rest assured that it’s always paid.

The same is true with investing. Those who focus on short term results seem to always be chasing the latest hot thing. They inevitably end up buying high and selling low because they are too focused on results and not enough on process.

Generating truly excellent investment results over the fullness of time requires an intense focus on process: the process of researching, analyzing, valuing, purchasing and selling partial ownership of businesses. Any focus on short term results that distracts an investor from this process will lead to sub par results. An intense focus on short term results will lead to disastrous decisions. Trust me, I’ve made them myself.

It’s hard to focus on process at times. Sometime an investment’s price will go down as business value goes up. Sometimes price will go up much faster than underlying value. Price is important, but it can distract you from underlying value.

The key is to have a process and discipline that you know will work, and to make sure you don’t get distracted by short term results when you know long term results are what’s important.

Even after 11 years of investing, I still find myself getting distracted by short term results. What do I do? I realize I’m letting it happen, then promptly and none too gently refocus myself back on the process. And, so far, that works.

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.