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Robust processes improve your outcome

In the Theory of Poker, David Sklansky writes “Any time you make a bet with the best of it, where the odds are in your favour, you have earned something on that bet, whether you actually win or lose the bet. By the same token, when you have a bet with the worst of it, where the odds are not in your favour, you have lost something, whether you actually win or lose the bet.”

Poker is often a good proxy for investments and investment theory. With a wide range of unknown outcomes, the consistently successful players are those that know the odds and play the probabilities game in and game out, as opposed to having a good gut feeling for a particular hand.

In their book, Winning decisions, Russo and Schoemaker use a simple matrix to explain the concept of outcome and process:

Good Outcome

Bad outcome

Good Process

Deserved success

Bad break

Bad Process

Dumb luck

Poetic justice

Simply put, this means because of probabilities, good decisions will sometimes lead to bad outcomes and bad decisions will sometimes lead to good outcomes.  Over the long term, however, process dominates outcome and this explains why the house at a casino makes money over time.

The decision does not become a good one just because it worked.  Focusing on the process does not guarantee a good outcome – it simply increases the odds of success.

Too often, investors focus solely on the outcome of an investment process, namely the returns. While this may be understandable as results are the ultimate long-term objective for any investor, a focus on short-term returns can be very misleading and harmful to an investor’s success. By focusing less on short-term results and more on how those returns were generated, and long-term results, investors are able to create the relevant anchors or reference points. This assists in harnessing the confidence to stick with one’s investment decisions in tough times.

Process is all about how decisions are made and Robert Rubin, the former US Treasury Secretary, imparts useful insight into decision-making in the real world:

· The only certainty is that there is no certainty. Investment managers, advisors and clients need to train themselves to consider a sufficiently wide range of outcomes (research shows that people tend to be far too optimistic and the range of outcomes they consider far too narrow).

· Decisions are a matter of weighing probabilities.  So, these should include both the probability (frequency) and the outcome’s payoff (magnitude). In other words, the issue in horse-betting is not selecting the most likely winner, but which horse is offering odds that exceed their actual chances of victory. In investments parlance, this relates to good companies often not being good investments because they are too expensive and all the good news is priced in.

· Despite uncertainty we must act. We do not have perfect information and need to make intelligent appraisals with the information we do have. Often investors make the mental error of assuming more information aids the process when often it simply adds to the confusion. An ability to distil large amounts of data into valuable information is a rare and a competitive advantage.

· Judge decisions not only on results but also on how they were made. A good process is one that carefully considers price against expected value and allocates capital accordingly.

Almost all investment managers with good long-term track records have robust processes. Managers with exceptional long-term track records often do things very differently, but across geographies and time there is evidence that certain characteristics are common. Investors should consider these characteristics when selecting an investment manager:

· A clearly defined sensible philosophy that has been tested through a range of market cycles

· A robust, repeatable process consistently applied

· Competent, passionate individuals

· A focus on downside protection

· A favourable and aligned organisational framework

· An emphasis on stewardship

Whether good or bad, investment managers have very little control over the outcomes in the short-term. What they can and should control is the process of decision-making and making sure that it is sound, sensible and consistently applied.

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