The Danger of Judging Decisions by Their Outcomes

Judging the quality of your decisions can be one of the most challenging aspects of investing. The process can seem simple on the surface because every investing decision you make produces a measurable result in the performance that it generates, but performance is not the obvious yardstick that many investors think it is.

The correct decisions in investing sometimes don’t generate the best results. The reason is that investing is not just a game of skill, especially over shorter-term time horizons. Luck also plays a significant role in determining investing outcomes. And in games where luck is a significant factor, it is essential to not judge the quality of your decisions solely by the outcome they generate.

Let me give you an example. Lets’ say that I think the market is about to collapse and I put a significant portion of my assets into a double inverse S&P 500 fund to try to capitalize when it does. Now let’s say that I am right and we get a 20% correction right away. My decision would have made me lots of money, so the result of it would be nothing but positive. But despite that, it was actually a horrible decision. I bet on a fund that is exceptionally risky and I made a low probability bet on top of that. The fact that I had a positive outcome does nothing to change the fact that I made a bad decision. This is obviously an extreme example, but investors do this all the time. We tend to judge the quality of our decisions by their short-term outcomes rather than focusing on the quality of the decision process that was behind them. That may work for a few decisions, but eventually, that type of process is bound to blow up.

I was listening to a great podcast with Peter Attia and Annie Duke recently and it really drove this point home. They discussed a four-quadrant matrix that can be very useful in judging decisions. We obviously all want to be on the top left of this matrix, but there are lessons that can be learned from all four quadrants.

Good Decision – Good Outcome    

Bad Decision – Good Outcome       

Good Decision – Bad Outcome

Bad Decision – Bad Outcome

As human beings, we tend to want to believe that good outcomes are the result of skill and bad outcomes are the result of luck. But implementing a process to try to honestly evaluate your decisions and to put them into the proper box on this matrix will significantly improve your decision making going forward.

Let’s look at some investing decisions that have and have not worked over the past decade and try to analyze them using this matrix.

Decision: Investing the US equity portion of your portfolio in a low-cost S&P 500 index fund   

Was the Outcome Good? Yes

Was the Decision Good? Yes

Clearly, a decision to invest in the S&P 500 over the past decade worked out very well. Almost anything you did to diversify any from it didn’t work. The vast majority of investing factors underperformed the index. Weighting your portfolio by almost anything other than market cap also didn’t work. So the results here were good.

But was the decision good when you take the outcome out of the equation? I would argue that it was. My factor investing friends would rightfully say the over the long-term buying the largest stocks and increasing their portfolio weights over time as they go up more isn’t a winning strategy. And that isn’t wrong. Research has shown that almost any weighting system beats market cap weighting in the long run. It has also shown that factors like value, quality and momentum can produce excess returns.

So why was this a good decision? The reason is simple. Index investing is a good decision for most people because of the role emotions play in investing. The excess returns that factors or alternative weighting schemes generate require looking different than the market. And looking different than the market means that investors are much more likely to abandon a strategy when it doesn’t work. For most investors, the excess returns generated by these factors are offset by poor decision making. So for your average investor, I think this was a good decision that had a good outcome.

Decision: Investing 100% of your equity assets in the US market

Was the Outcome Good? Yes

Was the Decision Good? No

International exposure has not worked out well over the past decade. Look at this chart of the S&P 500 vs. the MSCI EAFE index. Clearly you wanted to be invested in the US over this period.

But the long-term picture is very different. If you go back to 1993, International stocks have actually outperformed US stocks by a small margin. But the best argument for International investing isn’t a return based one. International investing has strong diversification benefits because of the reduced correlations that stocks in market’s outside an investor’s home country can offer.

Even though the US market is the least volatile of any global stock market, a global portfolio still offers lower volatility than a portfolio invested solely in the US.

So the fact that international diversification didn’t work in the past decade is not an indication that it doesn’t work long-term. And predicting this bad decade for international stocks in advance would have been very difficult. In my opinion, this is a case where a good outcome does not indicate a good decision.

Decision: Incorporating Exposure to Value Stocks in Your Portfolio

Was the Outcome Good? No

Was the Decision Good? Probably

I have spent a lot of time in previous articles talking about how value hasn’t worked in the past decade and looking at the reasons why, so I won’t cover it all again here, but perpetual low interest rates have certainly been a problem. The fact that the fast growing technology firms that value strategies typically don’t own have led the market upward and have disrupted the businesses of typical value companies also has. But could we have reliably predicted this in advance? Although hindsight is always 20/20, I don’t remember too many people calling for one of the worst periods ever for value a decade ago.

This type of thing is also certainly not unprecedented in the history of value investing. As the chart below shows, there have been other 10-year periods before where value underperformed, and it has always bounced back.

While it is certainly possible that we will all look back at this as the period where value investing died, the base rates would tell us that is not the likely outcome. Although having value exposure in the past decade didn’t work, I think it was still a good decision, at least for investors who can stomach the ups and downs that come with it.

A Framework for Making Sound Decisions

You may disagree with some of my conclusions above with regard to whether each of the decisions I discussed were good ones. But in many ways that is beside the point. The point is that if you solely judge your decisions based on their outcome, you are missing many opportunities to improve your investing process. The outcome of any decision certainly should be a factor in judging is quality, but it shouldn’t be the only one. Using the framework above has made me a better investor and I think it can help anyone make better decisions.

Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.