Focus on investment strategy, not outcome
(MoneyWatch) How many times have we seen the good outcome of a decision we made and thought, "I'm glad I made that decision"? The problem with that approach is that it could get us into much bigger trouble down the road, especially with our investments.
When we make that statement, we don't focus on how sound the decision really was. If we saw a good outcome from a poor decision, we become more likely to make that same poor decision again. We believe the outcome was much more likely than it actually was, a condition called "hindsight bias," or the idea that we see events as having been much more predictable than they were prior to actually occurring.
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Hindsight bias gets us in trouble in investing. Why? Because we might get lucky with an investment but believe that our logic was sound from the very beginning. It's not much different from a poker player making a crazy bet and only being able to win the hand if the king of clubs shows up as the final card. When that card shows up, it can entice the player to think the odds were much greater than the 4 percent chance he actually had.
Hindsight bias can bring undeserved rewards to irresponsible risk takers who take crazy gambles and win. The winners never get punished for having taken too much risk (leading to bad behavior such as what led to the financial crisis of 2008), only the losers do.
In his book, "The Signal and the Noise," statistician and New York Times columnist Nate Silver points out how good poker players avoid this bias. "They know that they can play well and win, play well and lose, play badly and win, and play badly and lose. They know the difference between process and results." Good card players know that they can only control the process (the strategy), not the outcome. "If you correctly detect an opponent's bluff, but he gets a lucky card and wins anyway, you should be pleased rather than angry, because you played the hand as well as you could. The irony is that by being less focused on results, you may achieve better results."
The same is true for investors.
Silver goes on to point out that "we are imperfect creatures living in an uncertain world. If we make a prediction and it goes badly, we can never be really certain whether it was our fault or not, whether our model was flawed or we just got unlucky."
Nassim Nicholas Taleb, author of "Fooled by Randomness," had the following to say on the problem of confusing strategy and outcome:
One cannot judge a performance in any given field by the results, but by the costs of the alternative (that is, 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).
With this in mind, here is the winning strategy for investors: Focus on broad global diversification, keeping costs low and tax efficiency high; don't pay attention to the daily noise (ups and downs) of the market; instead, rebalance and tax-manage the portfolio as circumstances dictate.
My experiences have taught me that it's important that we don't make the mistakes of taking credit for our forecasts that turn out to be correct (forgetting the role that luck plays) and placing too much of the blame for our incorrect forecasts on luck. Failing to do that leads to overconfidence, which in turn leads to all kinds of costly errors.
Bag of money image courtesy of Flickr user 401(K) 2012