Saturday, July 26, 2014

6 Signs of a Good Investment Process

In my baseball-playing days, I was on the mound in a big playoff game, and at a key moment in the game I threw what seemed to be a good pitch, only to watch as the ball sailed over the fence for a home run. It might still be traveling somewhere over North Jersey, it was hit so hard.

Walking back to the dugout after the inning was over, I was furious with myself for throwing the pitch. What was I thinking? What did I forget to do? What could I have done better? All natural questions to ask when you've experienced a bad outcome. 

In the dugout, I asked our catcher what he thought went wrong. He said, "Nothing at all. It was exactly what I called for and it was in the right spot. You've gotta tip your hat to the hitter -- he just took a great swing."

Nine out of ten times that pitch would have either led to a strike or an out. Instead, that time around the ball was hit out of the park. The process was right, the outcome was bad. If I could do it again, I would have thrown the same pitch...just perhaps a few more inches outside. 

This story from my glory days was on my mind this week as I was re-reading Michael Mauboussin's More Than You Know (which I highly recommend if you haven't already read it). 

The first chapter of the book is called "Be the House: Process and Outcome in Investing" and addresses the importance of process when making investing decisions. Here's an important quote from the chapter:
Results - the bottom line - are what what ultimately matter. And results are typically easier to assess and more objective than evaluating process.  
But investors 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...all emphasize process over outcome
When the market is strong, it's easy to fall into a false sense of confidence about your investment process because you're receiving almost daily positive reinforcement from rising stock prices. The opposite is true when the market is down -- you could have a good process experiencing bad short-term outcomes.

It's important to remember that there's a lot of randomness and luck involved in short-term market outcomes and they aren't indicative of investing skill.

What really matters is whether or not your investment process can survive short-term periods of positive and negative reinforcement and deliver longer-term results. In a probabilistic field like investing, a good process will produce good results over time and over a large sample.

How do you know if your process is any good? Each investor will have his or her own process, but in my experience I've found six common traits of a good investment process:
  1. Stoic: It can endure both good and bad short-term outcomes without getting emotionally swayed in either direction.
  2. Consistent: It doesn't adjust to current market sentiment and sticks to core competencies. 
  3. Self-critical: The process is periodically reviewed, includes both pre-mortem and post-mortem analysis on decisions, and is refined as needed. 
  4. Business-focused: Rather than rely on heuristics like "only buy stocks with P/Es below 15," a good investment process focuses on understanding things like the underlying business's competitive advantages (if any) and determining whether or not management has integrity and if they are good capital allocators.
  5. Repeatable: A process gets more valuable with each application -- insights are gained, deficiencies are noticed, etc. 
  6. Simple: The less complex, the better. If you can hand off your process to another investor without creating significant confusion, you're on the right track.
What do you think? Let me know in the comments section below or on Twitter @toddwenning

What I've been reading this week...
  • 5 investing lessons from Markel's Tom Gayner -- David Hanson
  • Cloning Neil Woodford's new dividend fund -- Monevator
  • Common sense investing guidelines -- Ben Carlson
  • A small cap CEO who reads Buffett and Graham -- MinnPost
  • Beware when a CEO leaves for no apparent reason -- MoneyWeek