Friday, March 18, 2016

Process vs. Outcome

Recently a well known financial advisor wrote a very good article concerning the difference between investing process and investing outcome.  It is easy to read and he provides some great examples so I encourage you to check it out:
I think his final paragraph summarizes the concept very well:
“We never really know what the source of a good outcome is; however, we have a high degree of confidence what the probabilities are for a good process. A strong process is a guarantee — not of outcome or results, but of the highest probability of obtaining desired results. That’s why it is so important to investors.”
If you are a client of ours or have been reading our emails for any length of time you know we constantly preach to focus only on what you can control.  You can control the process that creates your financial plan and investment strategy.  Things you can control do NOT include:
·       Stock market performance
·       Which market will do best
·       The economy
·       The next President
These statements often seem counterintuitive to what the typical person gets sold by the investing community.  Traditional investment advice is the exact opposite.  Investors are told to find the person who is best at picking the next Apple or who knows the direction of China’s economy.  The implication is that only with the knowledge of these things can you be successful at investing.  However, the truth is that developing an investment strategy based on predicting outcomes rather than processes nearly always leads to poor results and sometimes destroys retirement portfolios.
A specific example helps illustrate the importance of process over outcome.  The past few years have seen the US large cap stock market perform fairly well while many other markets, even within the US, have struggled.  Below is the well know “quilt chart” showing different country performances over the past 20 years.

It is easy to see that the US was the top performer in 2013 and 2014 and eked out a positive gain in 2015 even though 2015 was a negative year for many markets around the world.  Looking at this performance the emotional part of our brains fires out thoughts like:

“Why are we underperforming?”
“Should we be investing outside the US?”
“Should I get rid of stocks?”
While these initial reactions are normal, they are actually produced by some strong behavioral biases and focus on outcome rather than process.  I will leave the behavioral biases for another time (I have written about them before here and here).  My focus now is on process vs. outcome.
The statements above all suggest it would be better to have a concentrated portfolio that only holds the top performing investment each year and that risk is defined as underperforming the S&P 500.  When we contemplate that statement for a few moments the non-emotional part of our brain can easily see that thinking is incorrect.  There is no sound process that would lead to someone only owning the S&P 500 the past 3 years.  In fact, the only processes that could have led to such a portfolio would be extremely hazardous to your financial future.  Below are examples of such bad processes:
Poor Processes
Creating over-concentrated portfolios, changing your portfolio based on market predictions, and defining risk as underperforming a single index.

These poor processes all leave our investing success tied to things that are completely out of our control.  If you take another look at the quilt chart above, you can see the US was in the bottom 50% of performers from 2000 to 2009 and actually had a negative total return over that period.  Making a concentrated bet certainly can pay off in a given year or two, but we know from over 100 years of data that maintaining a diversified portfolio over time is the best process to maximize return for a given level of risk.  Below are a few examples of sound processes in contrast the poor processes above:
Sound Processes
Creating diversified portfolios, changing your portfolio based on personal goals or life changes, and defining risk as not meeting your long term goals.

As wise investors we must create sound processes built only on what we can control.  Giving up sound processes in an attempt to chase short term outcomes is a guaranteed recipe for disaster.  At Legacy Financial Group we use all the financial knowledge and research available to develop truly world class investment processes that go into each and every portfolio and financial plan.

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