It's all about the thought process

Michael Mauboussin recently published a detailed discussion of investment performance entitled "Untangling Skill and Luck: How to think about outcomes -- past, present, and future." Many of his conclusions agree with convictions we have held for many years and which we have discussed in this blog before, and we feel that the basic lesson at the heart of the essay is one that is extremely important for all investors.

After pointing out that luck and skill interact in the world of investment management, just as they do in many sports and other human endeavors, and offering some tools for evaluating and observing the interaction of luck and skill and measuring performance, he concludes with a discussion of the crucial importance of a sound investment process, what Warren Buffett describes in the essay's concluding quotation as the "framework for investment decision making." We would argue that this idea is crucial to investing, and would add that what really matters is:

a) the soundness of this basic thought process


b) the consistency with which this basic thought process is applied over time.

We believe that there are many fundamentally sound thought processes from which to choose, much as there are many fundamentally sound martial arts from which to choose, as we discussed in a post at the beginning of 2009. As touched on in the article referenced above, many investors focus too much on investment "style" when they should be focused on the quality and consistency of the process (while there are investment styles with which we have fundamental disagreements, we believe that many "growth" and "value" styles, if applied properly, can be fundamentally sound).

The problem is that most investors (and their professional advisors or investment management consultants) switch from one to another, depending upon which one is most popular or which investment style appears to be doing the best in the short term, and end up getting seriously hurt (much the way someone who dabbles in one martial art after another without much consistency can also end up getting seriously hurt in a real situation).

We believe that overwhelming evidence suggests that this lack of a consistent thought process is at the heart of the long-term failure of many investors to make money, or even stay ahead of inflation. Investors tend to switch money managers frequently (every two to three years), making it impossible to have a consistent thought process governing their investment selection for decades.

We have presented this evidence in several previous posts, including here and here. Back in early 2008, we also noted evidence that, by switching from one manager to another in a similar fashion, institutional investment management consultants appeared to be causing the same self-inflicted wounds that retail investors routinely suffer. Mr. Mauboussin's piece cites a more recent study published in the Financial Analysts Journal November/December 2009 issue which found that such switching cost institutional investors over $170 billion from 1985 to 2006, which could have been prevented "if they had simply stayed the course."

We believe that the importance of having a sound thought process and of consistently sticking to that thought process simply cannot be overstated. We have discussed this before in "The same thought process for 30+ years."

Unfortunately, with the current structure of the financial industry, it is difficult for many investors to get a consistent process for decades. Investors either have to develop their own process (preferably while they are still young) and then stick to it for their entire investing lifetime, or find a money manager whose thought process they believe is fundamentally sound and with whom they can invest for decades.

We commend Mr. Mauboussin for his valuable contribution to this important issue.

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For other previous posts in which we discuss this important subject, see also: