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The value of the investment process
“Any time you make a bet with the best of it, where the odds are in your favor, you have earned something on that bet, whether you actually win or lose the bet. By the same token, when you make a bet with the worst of it, where the odds are not in your favor, you have lost something, whether you actually win or lose the bet.” – David Sklansky, ‘The Theory of Poker’
Over a lifetime, active investors will make hundreds, often thousands of investment decisions. Not all of those decisions will work out for the better. Some will lose and some will make us money. As humans we tend to focus on the outcome of the decision rather than on the process.
On a behavioral level, this makes sense. The outcome is binary to us – good or bad, we can observe with ease. But the process is more complex and is often hidden from us.
One of two things (sometimes a bit of both) can unite great investors: process and randomness (luck). Unfortunately, there is not much we can learn from randomness, as it has no predictive power. But the process we should study and learn from. To be a successful investor, all you need is a successful process and the ability (or mental strength) to stick to it.
Several years ago, I was on a business trip. I had some time to kill so I went to a casino to play blackjack. Aware that the odds were stacked against me, I set a $40 limit on how much I was willing to lose in the game.
I figured a couple hours of entertainment, plus the free drinks provided by the casino, were worth it. I was never a big gambler (as I never won much). However, several days before the trip I had picked up a book on blackjack on the deep discount rack in a local bookstore. All the dos and don’ts from the book were still fresh in my head. I figured if I played my cards right I would minimize the house advantage from 2-3 per cent to 0.5 per cent.
Wanting to get as much mileage out of my $40 as possible, I found a table with the smallest minimum bet requirement. My thinking was that the smaller the hands I played, the more time it would take for the casino’s advantage to catch up with me and take my money.
I joined a table that was dominated by a rowdy, half-drunken blue-collar worker who told me several times that it was his payday (literally: he was holding a stack of $100 bills in his hand) and that he was winning. I played by the book. But it did not matter. Luck was not on my side and my $40 was thinning with every hand.
Meanwhile, the rowdy guy was making every wrong move. He would ask for an extra card when he had a hard 18 while the dealer showed 6. The next card he drew would be a 3, giving him 21. Then the dealer would get a 10 and then a 2 (on top of the 6 that already showed), leaving him with 18. The rowdy guy barely paid attention to the cards. He was more interested in saying “hit me”.
Every “right” decision I made turned into a losing bet, while every “wrong” decision he made turned into a winner. His stack of chips was growing while mine was dwindling. His loud behavior and consistent winnings attracted several observers. Some were making comments such as: “This guy is good.” Nobody paid attention to me – I was not loud and I was losing.
The rowdy guy had no process in place. He was just making half-drunken bets that had statistical improbabilities of success. And he was winning, at least for a while. I was armed with statistics, making every bet to maximize my chances of winning (actually, to minimize my losses – the odds were still against me) but I was on the losing side of the game.
After a couple of hours, and of consuming more of the “free” alcohol, my rowdy companion was increasing the size of his bets with every successful hand. The law of large numbers caught up with him. He gave up his winnings and his pay check as well – two weeks of hard work rightly went into the casino’s coffers.
I was down to a couple of dollars at one point. But then my luck changed and I won the bulk of my money back. In the end I lost only $10. This was a successful deal. I’d had a couple beers, spent a couple of hours gambling and learned a valuable gambling/investing lesson about the value of the process.
What is the lesson? Spend more time focusing on the process than on the end results. If it was not for randomness, every decision we made would be right or wrong based solely on the outcome. If that were the case, the process could be judged solely on the end result.
But randomness is constantly present in investing (as it is in gambling). Though we are drawn to judge our own decisions, and those of others, on their outcomes, that is dangerous. Randomness may teach us the wrong lessons.
Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo. He is the author of "Active Value Investing: Making Money in Range-Bound Markets" (Wiley 2007). To receive Vitaliy's future articles my email, click here.
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Many traders and 'investors' enter the Market to victimize themselves and lose. This is the prime motivation for them. U.S. is essentially not only a nation of Sheeple but one instinctively of Victims who indulges the habit of blame like an addict uses his heroin.
the drunk playing cards was sitting down to lose and get high off the adrenalin of losing.
..or could he be playing with his dreams, fantasizing for a short time at least what life would be like with big winnings as most lottery players who painstakingly spend hours choosing just the right numbers to play and an equal amount of time standing at the cash register to buy the tickets?
That hardly seems like victimization.
Could be both.
now there's a theory to grind on... wow.
perhaps it's based on the whole Catholic Guilt (CG) thing, given its prevalence in early American cultural formation... Or is CG yet another manifestation your asserted human urge to self-suffer for some strange reason.
interesting idea. do i need a dose of profits or pity today? hmmm :^)
a trade is not an investment.
dont confuse the two. A trade is a probability assessment based on the limitations of the traders awareness.
unequal distributions of awareness account for the diferrences in probable outcomes.
Investing and trading are different sides of different coins.
one has simple identity and the other has complex identity.
to know the difference is a life lesson.
+1
Obvious as it sounds, a trade is a committment to something you want (even if it's because you think someone will want it more later) or it's something you don't want anymore.
Even with T/A and Wave theorists, trades are subjective in the market at large given that a T/A-Wave theorist makes the ultimately subjective choice to trust his/her patterns/algos/math.
Cards are purely statistical. Within that framework, they are also randomly distributed. However, as you get closer to the end of the deck(s), you do "know" more - e.g. past performance *is* an indication of future performance. The market has no such insurance (that I know of, yet!) except perhaps for the HFT insiders.
To those who don't trust Vitaliy's thesis of process over results, the implied assumption is that the process should (slowly?) change with better understanding of market conditions, and will ultimately 'see' through the 'noise'. This all assumes the chosen process has any viable binding to the relevant market forces. Often that binding is more subjective than not. See the various market debate sites (seekingalpha, etc.) for proof.
While I'm currently "up" on my YTD totals, lately my processes don't seem be very well bound to the current forces driving the market :^) Thanks to TD and crew, I understand why.
Good article, Vitaliy.
Quality post.
In trading or gambling those who don't understand its significance are doomed to long term failure unless they are very very lucky. Sadly it also means that even if you are really gifted you can still fail if you are very very unlucky.
Randomness plays a huge role in human life outside the gaming table or the market. It is a shame some of the contributors on the weirder threads on this site don't appear to understand this aspect of life
It's a rioutously chaotic and random result that any of us exist, given that the odds of 1 sperm out of 300,000,000 unites with one egg.
Seems to be a symmetry in that.
difficult to compare poker to investing. in poker, the odds are known, in investing, they never are.
Sklansky is a genius and theory of poker is an excellent book. That book put me through college.
Sadly, I'm not as good of an investor as I am poker player.
Investment strategy extreme.
Throwing darts!
This is a definite cause for concern...but what is really going on?Is it a plan to enable giant profits thru scare tactics?
I draw a different conclusion: The drunken guy did not control his risk at all. Psychologically, he wins, wins, wins and thinks that this will continue while in fact it is only luck. One improvement is to take always half the winnings of the table and put them safely away. (Jesse Livermore stated that he should have followed this rule consequently)
While the process is important, claiming that the process is more important then the outcome does not make sense at all. In a trade there is a winning side and a losing side; the investment process should improve the odds of being on the winning side.
One important feature of an investment must be to call major turning points to be able to keep the gains in the long term. Imagine you held gold from 1980 to give up disgruntled in 2000 or stocks from 1966 until 1982. If you refer to the concept of randomness or the random walk theory, this so called random has distinct patterns that can be made visible; they have even some predictive value, the people recognizing them stated that the predictions based on these patterns are seven out of ten times correct.
Haven't you watched "21"? The loud drunken guy was the distractor, while the girl next to you was counting cards, and the guy next to her was making the big bets. And now, I go pour myself a drink...
When I allocated to hedge funds, I always asked them to discuss their major drawdowns. I was looking to see what went wrong, and more importantly, how they responded. It's all about people and process. Any idiot can make money in a bull market.
randomness pretty much describes how I started trading, lol.