Decisions, Decisions
How you go about deciding is perhaps more important than the actual decision itself.
Decisions are an integral aspect of protecting and building wealth. Last month’s Investment Insights was about how to make a decision happen. This month will be about making the actual decision. Specifically, the process of making an investment decision.
Every choice is unique and requires a tailored approach. Perfect accuracy is impossible. The best to hope for is to be right more often than wrong and to count the most important decisions among those correct. The principles described herein, by no means an exhaustive list, are intended to increase your chances of success. Ideally, these concepts will prove timeless, adaptable across a wide array of decisions spanning many aspects of life.
By one taxonomy, there are four types of decisions. The simplest are choices with a known range of outcomes and known probabilities. Think flipping a coin or rolling a die. Few decisions are like this, however.
In reality, decisions are more complicated. There can be unknown outcomes and known probabilities, such as buying a mystery box, or the opposite, known outcomes and unknown probabilities, such as wagering on a horse race.
Investment decisions, like most decisions, fall in the fourth category, unknown outcomes and unknown probabilities. You don’t know everything that could happen. Consequently, you have no idea how likely it is for anything to happen. This is a challenge.
Making matters worse, investment decisions can deceive you. A properly made decision can still be unsuccessful and an improper decision can still be successful. Worse yet, a properly made, successful decision can appear initially incorrect and remain so for quite some time. Similarly, improper, unsuccessful decisions can at first look to be correct.
Due to compounding, small, seemingly innocent investment decisions today can have large consequences in the future. Bad investment decisions can sometimes be catastrophic. Nor are investment decisions static. A good decision at one price and time can become a bad decision at another.
Our psychology makes investment decisions even harder. Humans are extremely effective rationalizers. Admitting error can threaten our self-image. Numerous studies have shown that we refuse to change our mind, even when presented with evidence to the contrary.
Investment decisions are also influenced by peer and social pressures. Going against the crowd is hard. No one wants to risk exclusion or embarrassment. Successful investment decisions, however, often require contrarian thought.
No two investment decisions are identical. This limits the ability to learn from past decisions. Only abstractions can be applied to the future.
Fear not. While investment decisions are challenging, there are ways you can improve your chances of success. You still won’t be right every time, but if you can be right more often than wrong, consistently, for a long time, you will reach your goals.
A good start is to write down the rationale for your decision. Be specific, as if explaining your choice to an uninformed third party. You want your reasons for the decision to be disprovable. When you revisit your decision later, you will clearly understand why you chose the way you did and it will be harder to rationalize a clearly incorrect choice.
Journaling also helps to avoid impulsive decisions. Often things we think we understand clearly in our mind do not hold up when put to paper.
Framing the range of outcomes and the probability of each helps improve decision quality. Do this as best and as clearly as possible. The value is not in getting it right (you won’t and that’s okay), but in thinking it through. As events unfold, incorporate new information to improve your initial assessment. Never stop making the decision
Post-mortems are another effective tool. After a choice is made and an outcome observed, compare it to the initial expectations in your decision journal. Look at what went right and what went wrong. Pay special attention to learnings that can improve your process for making the next decision. Iterate this enough and your decisions, on balance over time, are bound to improve.
Lastly, avoid decisions with the potential for significant loss, even if the probability is quite low. Recall how compounding works. It is better to avoid large losses than risk them in pursuit of big gains. If you lose 75% of your money, you have to quadruple what remains just to get back to where you started.
I had previously commented that investing, at the highest level of abstraction, is simply about return and risk. One level down, investing is about making decisions properly in the context of uncertain return and risk.
Investment decisions are particularly hard because they often take a long time to play out. In the interim, it is easy to be fooled. Eventually you lose sight of why you made the decision in the first place. Our propensity for rationalization and susceptibility to peer and social pressure can make success seem nigh impossible.
No perfect solution exists. However, you can improve your odds. Write down your rationale. Frame the range of outcomes and update it for new information. Create a feedback loop to drive iterative improvement. Work to avoid situations where there is a risk of material loss. When it comes to protecting and building wealth, how you go about deciding is perhaps more important than the actual decision itself.
Thoughts? I would love to hear them. Email me at investmentinsights@zuckermaninvestmentgroup.com.
Written By Keith R. Schicker, CFA