It shows that people don’t know the rules or they refuse to follow the rules perfectly.

It also shows that people make the wrong decision all the time and get lucky. And worse, they and others celebrate it as the correct choice because the outcome worked in their favor. When things are going well, I must be doing things right. Isn’t that how it goes?

DePodesta provided a matrix to help explain this:

process decision matrix

We all want to be in the upper left box — deserved success resulting from a good process. This is generally where the casino lives. I’d like to think that this is where the Oakland A’s and San Diego Padres have been during the regular seasons. The box in the upper right, however, is the tough reality we all face in industries that are dominated by uncertainty. A good process can lead to a bad outcome in the real world. In fact, it happens all the time. This is what happened to the casino when a player hit on 17 and won. I’d like to think this is what happened to the A’s and Padres during the post-seasons.

As tough as a good process/bad outcome combination is, nothing compares to the bottom left: bad process/good outcome. This is the wolf in sheep’s clothing that allows for one-time success but almost always cripples any chance of sustained success — the player hitting on 17 and getting a four. Here’s the rub: it’s incredibly difficult to look in the mirror after a victory, any victory, and admit that you were lucky. If you fail to make that admission, however, the bad process will continue and the good outcome that occurred once will elude you in the future. Quite frankly, this is one of the things that makes Billy Beane as good as he is. He is quick to notice good luck embedded in a good outcome, and he refuses to pat himself on the back for it.

At the Padres, we want to win every game we play at every level and we want to be right on every single player decision we make. We know it’s not going to happen, because there is too much uncertainty… too much we cannot control. That said, we can control the process.

Investors get into a lot of trouble confusing dumb luck with deserved success. There’s nothing wrong with having some luck. The problem is when we confuse it with skill. And similarly, confusing bad luck with a bad decision.

Unlike Mr. “Hit on 17”, we should judge decisions independent of the outcome. That’s not the easiest thing to do, especially in investing when a bad outcome produces real financial losses.

The first step is accepting that any investment process is imperfect. It will not produce good results every single time. A good process, that exploits edges, delivers bad breaks sometimes but will win out if given enough time.

Enough time is key. The role of good behavior — patience, discipline, fortitude — in this, can’t be understated. We have to stick it out through the bad breaks to get the long-term desired results.

Then we have to be humble enough to be critical of those decisions whether things are going well or not. James Montier, in his book, sums it up like this:

Focusing on process seems to lead to better decisions.

The same is true in investment. Focusing upon process frees us up from the worrying about aspects of investment which we really can ’t control—such as return. By focusing upon process we maximize our potential to generate good long-term returns.

Unfortunately, focusing on process and its long-term benefits won’t necessarily help you in the short term. During periods of underperformance, the pressure always builds to change your process. However, a sound process is capable of generating poor results, just as a bad process can generate good results. Perhaps we would all do well to remember the late great Sir John Templeton’s words, “The time to reflect on your investing methods is when you are most successful, not when you are making the most mistakes, ” or indeed Ben Graham’s exultation, “The value approach is inherently sound … devote yourself to that principle. Stick to it, and don’t be led astray.”

Draft Review – About Process – Paul DePodesta
The Little Book of Behavioral Investing – J. Montier

For more investment strategies, visit the Portfolio Construction Channel.