More than You Know: 1: Be the House: Process and Outcome in Investing

Here's a chapter that categorically denies the validity of "the end justifies the means"--particulary if the "means" is absent or deficient! I found this chapter to be a very good start to the book. The tenet here is that a good process will provide consistently better outcomes. A sloppy process can still yield success, but not consistently so.

M points out that, "The goal of an investment process is unambiguous: to identify gaps between a company's stock price and its expected value." (p. 10) Sounds simple enough. He goes on to note, "A thoughtful investment process contemplates both probability and payoffs and carefully considers where the consensus--as revealed by a price--may be wrong." (p. 11)

M quotes Robert Rubin's Harvard Commencement Address, 2001. He notes four principles for decision making:

1. The only certainty is that there is no certainty.
2. Decisions are a matter of weighing probabilities.
3. Despite uncertainty, we must act.
4. Judge decisions not only on results, but also on how they were made.
   

(pp. 11-12)

I was quite struck by these as these are the tenets that I've used in my business decision making over the years. I will also tell you the ONE that I've always grappled with is using probability distributions to create an expected value. Why? To create these distributions with any accuracy you have to be able to (1) anticipate the correct population of outcomes and (2) assign the correct probabilities to those outcomes. I've been pretty comfortable with identifying the population of outcomes, but assigning probabilities is not always easy if there is little or no historical information to inform the probability assessment. Frankly, this is the venue in which you can essentially "massage" the probabilities to get to your desired result (meaning: managing the outcome).

With respect to investing, I'd have to ask the question as to how much information does the average investor have to provide a credible construct of an outcomes probability table? That difficulty notwithstanding, it is a useful discipline. If a company's fortunes depend on their getting a drug approved, a permit issued or a successful conclusion of thorny lawsuit this is still useful information.

If you have NuevaPharma (fictitious), that is trading at $10 per share, and the investment community is waiting for the FDA to determine if its cancer drug is going to be approved one could construct the following table:

You see everyday where these types of FDA decisions either launch a company into the stratosphere or cause a meteoric crater from its crashing and burning. Here's an example where there is probably decent information regarding the $ potential of a "yes" decision--and that would be your guide to assigning the Price Appreciation percentage. How you would have any confidence about the percentage probability to assign the outcome is tough.

There is a key piece of information that is not in the table. What do you think it is? It's the hurdle rate--the line in the sand that you need to clear in order to get to a "Yes" decision. In order to take such a risk with your money, you have to assign what YOUR minimum expected payoff would need to be in order to do the all important Number 3--TO ACT.

Let's get back to the tenet of the chapter which is process. Let's suppose that two people were making a decision: You and me. Let's say that you went through the above process, but it did not meet your hurdle rate of 25%; accordingly (and appropriately), you passed on the opportunity.

Let's say that I engaged in NO process, and I made a "What the hay" decision. It looked "interesting" for no other reason than it caught my fancy. I invested on a whim, and the stock took off like a rocket--doubling within minutes of opening after the FDA's morning announcement. You got the whole thing wrong. The probabilities were wrong, and the price appreciation was cockeyed.

Was I the better decision maker because I had a better outcome? The answer is categorically NO. I was lucky. The investor that engages in a disciplined process (expected outcomes, fundamental analysis, etc) will have better consistency of good outcomes than a willy-nilly approach which is founded upon dumb luck.

Even though I wrestle with the assignment of probabilities, even when many decisions are binary--it will either be approved or NOT--assigning probabilities quantifies my risk and my payoff. The hurdle rate is a combination of the magnitude of the outcome and its probability. Constructing a table helps one understand this important dynamic and at least requires one's assigning some confidence to the model. Whether one makes a multi-million investment decision for one's company or a multi-thousand investment decision for one's portfolio, one is accountable for the outcome.

I will tell you that in business, a screw up with a good process is much better tolerated than a screw up with no process. If you the outcome differs, you can go back to your decision making model and determine where the breakdown occurred. That's how one learns from mistakes and improves future decisions.

The above is the lesson of Chapter 1. (These are my examples, not the book's).

To reinforce the importance of acting, I also ran across this from Richard Russell's website. I hope that you'll take a minute to read it.