“That’s part of the game…Sometimes that stuff happens.” – Bill Belichick
Over the weekend I read a blog post entitled Lessons From Losing Big by Ben Carlson, who is a fellow CFA charter holder and like-minded investment advisor. In his post, Ben highlights some of his key takeaways from the book What I Learned Losing a Million Dollars, which was written by a former Chicago Mercantile Exchange futures trader who made and subsequently lost a large amount of money at a fairly young age. Of the several different nuggets that Ben highlights from the book, the ones that jumped out at me centered on the difference between processes versus outcomes.
As most of our clients and long-time readers know, I had the esteemed honor of attending Stanford University to complete a graduate degree in a program called Management Science & Engineering, which I like to tell people is akin to a MBA for math and science nerds (engineers). During my time at Stanford, I experienced several paradigm shifts in my understanding of how the world works. One of the most profound shifts was that the merits of any particular decision shouldn’t necessarily be tied to the outcome it produces.
The human brain processes information in a linear fashion…A+B=C. The problem is, we do not live in a linear world. The world we live in is a very complex system with lots of moving parts and plenty of good old fashion chance/luck at play. Mathematicians have coined the phrase chaos theory to explain these types of complex systems where small changes in any number of variables can produce dramatically different outcomes. The classic example of chaos theory is weather patterns, which anyone living in Colorado is intimately acquainted with the fact that small changes in nature can lead to dramatic and unexpected changes in the weather.
Because systems are complex and often times non-linear, it is almost impossible to point to a single cause for every effect. Which brings me back to my paradigm shift in thinking about how to judge decision making under uncertainty. Let’s look at a couple examples. Going back to the weather, let’s say that one day you wake up and see the weather forecast is predicting rain, so you dress accordingly and grab an umbrella before heading out the door. As it turns out, the forecast was incorrect (a common occurrence when forecasting a complex system) and it didn’t end up raining that day. Since the outcome was the opposite of what was expected, does that make the decision to dress for rain and grab an umbrella wrong? Of course not, because the decision to prepare for rain was based on the best available information you had at the time the decision was made. Whether or not the outcome ends up validating the decision or not is completely beside the point.
This idea of judging decisions based on process rather than outcome is revolutionary. Quoting Ben Carlson who was in turn quoting the aforementioned book:
In 20/20 hindsight, decisions might be good or bad but not right or wrong.
In other words we can judge whether a decision to do something was a good or bad decision based on the outcome but not whether the decision was right or wrong. I’m reminded of a Sunday Night Football game back in 2009 between the New England Patriots and Indianapolis Colts. Both Peyton Manning and Tom Brady where in top form that evening in a true offensive battle. With a little over two minutes left in the game and a six point lead, Bill Belichick made the highly controversial decision to not punt the ball and go for the first down on 4th & 2 from his own 28 yard line. The Patriots ended up coming up short on the play and Peyton Manning drove the Colts down the short field to score a game winning touchdown. Game over. Patriots lose by 1. Pretty much everyone looked at the bad outcome and determined that Belichick had made the wrong decision to go for it rather than punt on 4th down from his own 28 yard line.
Now I have no love loss for the Patriots and as a dyed-in-the-wool Broncos fan, I’m happy to see them lose. But I have an immense amount of respect for Belichick and his approach to coaching which is scientific and calculated to say the least. I found several sources from a quick search on the internet which indicated that the probability of converting a 4th & 2 from that spot on the field was in the 60% - 70% range. So right off the bat, Belichick knows that the odds of converting are greater than failure. Knowing this, he then had to consider what he felt the probability of Manning scoring a TD from their own 30 yard line (if they failed on 4th down) or from the Colts own 25 yard line (using an average net punt distance of 45 yards). In my opinion, Belichick simply decided that he had more to gain by going for it on 4th & 2 than by gaining 45 yards of field position and still putting the ball in Manning’s hands with 2 minutes to go in the game. Nobody knows for sure what the actual probability of success was for the Patriots in that situation on that given night or on Manning orchestrating a game winning TD drive from different points on the field, but the point is that when we look at the process of the decision rather than just the outcome, we can at least understand and at most validate the decision even though it led to a bad outcome (for Pats fans that is).
The same is true in investing. There are lots of highly successful and extremely rich investors who were simply in the right place at the right time and there are probably even more (we don’t know for sure because media outlets don’t cover these stories) unsuccessful ones who have a sound process in place but have been “unlucky” with their outcomes. Now I’m not saying that outcomes don’t matter as the goal of investing is to make money, but what I am proposing is that over short periods of time comparing the returns of investment strategies A through Z is not proof positive of one’s superiority over the others. The shorter the time frame, the more luck/noise can play a huge roll in the outcomes/returns.
Doing the “wrong thing” (i.e., breaking your rules) in the markets and still being rewarded means you will repeat behavior that may or may not have been responsible for the profitable trade or investment.
The global economy is an extremely complex system with millions of different variables that can have dramatic changes on future outcomes. Our job as investment advisors is not to try to draw some linear conclusion by forecasting the future, which is a fool’s errand at best. The number one job we have as portfolio managers is to manage risk by effectively allocating capital in the face of uncertainty.
All you can actually determine is the amount of your exposure as opposed to the probability that the market will or will not go to a certain price. Therefore, all you can do is manage your exposure and losses, not predict profits.
So how do we manage risk? We apply a principle called The Economics of Loss by building portfolios that go beyond just stocks and bonds (Diversification 2.0) as well as applying our proprietary trend following model (MarketVANE) to proactively manage downside risk. Is it a perfect strategy? No. Does it win all the time? No. Is it a defensible strategy that provides downside protection while reducing volatility drag in the portfolio and the cost of being human (e.g. making emotional rather than rational decisions at inopportune times)? Absolutely! This is one reason why we spend so much time on this blog and in face to face meetings with our clients unpacking and explaining our process as well as the results. In order to judge the efficacy of an investment strategy, we must take the time to fully understand the process rather than only considering the outcomes.
Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.
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