As expert poker player Annie Duke explains in her book, Thinking in Bets, one of the more common mistakes amateurs make is the tendency to equate the quality of a decision with the quality of its outcome. Poker players call this trait “resulting.”
In my own book, “Investment Mistakes Even Smart Investors Make and How to Avoid Them,” I describe this mistake as confusing before-the-fact strategy with after-the-fact outcome. In either case, it is often caused by hindsight bias: the tendency, after an outcome is known, to see it as virtually inevitable.
Duke explains: “When we say ‘I should have known that would happen,’ or, ‘I should have seen it coming,’ we are succumbing to hindsight bias.” She adds that we tend to link results with decisions even though it is easy to point out indisputable examples where the relationship between decisions and results isn’t so perfectly correlated.
For example, she writes, “No sober person thinks getting home safely after driving drunk reflects a good decision or good driving ability.” The lesson, as Duke explains, is that we aren’t wrong just because things didn’t work out, and we aren’t right just because they turned out well.
Don’t judge performance by results
“Fooled by Randomness” author Nassim Nicholas Taleb put it this way: “One cannot judge a performance in any given field by the results, but by the costs of the alternative (i.e., if history played out in a different way). Such substitute courses of events are called alternative histories. Clearly the quality of a decision cannot be solely judged based on its outcome, but such a point seems to be voiced only by people who fail (those who succeed attribute their success to the quality of their decision).”
Here's an example from poker. With one card remaining to be drawn, there are just two players left in the hand. Player X calculates that he has an 86% chance of winning. Based on those odds, he makes a large bet. Unfortunately, he loses the hand, just as he would expect to occur 14% of the times he faced the same situation. If he engaged in resulting, he would change his betting strategy because he would conclude that it was wrong to make such a bet. However, we know that if he made the same decision each time he faced those odds, over the long term, he would be expected to come out way ahead.
Let’s look at another example of resulting. John Smith, a hypothetical investor, works for Google and has nearly his entire portfolio invested in Google stock. He became a multimillionaire based on that strategy. John believes concentrating all your eggs in one basket – a basket that, as a senior executive, he could watch closely – is the right strategy. He thought diversification was only for investors who don’t have his sophistication. Of course, many other, similar situations turned out entirely differently, despite using the same strategy of concentrating risk in what you know. That’s why the saying “the surest way to create a small fortune is to start out with a large one and concentrate your risk” offers such good counsel.
Among the once-great companies whose stock prices collapsed are Polaroid, Eastman Kodak, Digital Equipment, Burroughs and Xerox. However, despite the fact that there are far more Polaroids than Googles – showing John’s strategy is flawed – his outcome convinced him the strategy was right.
As Duke points out, once a belief becomes lodged, it becomes very difficult to dislodge. It takes on a life of its own, leading us to notice only evidence that is confirming, and causing us to experience cognitive dissonance. We then work hard to actively discredit contradicting information, a process called motivated reasoning.
Making matters worse is that research shows being “smart” actually makes certain behavioral biases worse: The smarter you are, the better you are at constructing a narrative that supports your held belief.
Duke cites the research of Richard West, Russell Meserve and Keith Stanovich, who tested the blind-spot bias. They found we are much better at recognizing biased reasoning in others but are blind to recognizing it in ourselves.
Surprisingly, at least to me, West, Meserve and Stanovich also found that the better you were with numbers, the worse the bias – the better you are with numbers, the better you are at spinning those numbers to suit your narrative. Quoting Duke: “Our capacity for self-deception knows no boundaries.” So, what does this have to do with investing?
Invest by playing the odds
When it comes to investing, there are no clear crystal balls. Just as in poker, the best we can do is put the odds in our favor and invest (bet) accordingly.
As I recently discussed, using factor data from Dimensional Fund Advisors from 2007 through 2017, the value premium (the annual average difference in returns between value stocks and growth stocks) was -2.3%. Unfortunately, resulting, hindsight bias and recency bias led many to conclude it was a mistake to invest in, or overweight, value stocks.
Another way to look at the situation is that, over 10-year periods since 1927, value stocks outperformed growth stocks 86% of the time – the same percentage as in the aforementioned poker hand. The value premium’s now-decade-long underperformance was not unexpected, in the sense that in 14% of the alternative universes that might have shown up, we expected value stocks to underperform.
Similarly, again using Dimensional Fund Advisors data, the market-beta premium has been negative (U.S. stocks underperformed riskless one-month Treasury bills) in 9% of the 10-year periods since 1927.
In other words, investing is risky. To be successful, you must accept that fact there will be periods, even very long ones, when the right strategy leads to poor outcomes. Even at 20-year horizons, the market beta premium has been negative 3% of the time. That is why Warren Buffett has said investing is simple, but not easy. It takes discipline to earn risk premiums.
One of the hardest things for investors to do is to stay disciplined when their strategy delivers poor results. It certainly is possible that the strategy was wrong. To determine if that is the case, look to see if the assumptions behind the strategy were correct. Seek the truth, whether it aligns with your beliefs or not. For investors, the truth lies in the data. When your theory isn’t supported by the data, throw out your theory.
While it’s certainly not an investment book, investors can learn many lessons from Duke’s “Thinking in Bets.”
Larry Swedroe is the director of research forThe BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country