The Best Long-term Performers in any Probabilistic field emphasize PROCESS over OUTCOME.

Process versus outcome

Probably the best discussion that I've seen about this issue comes from Michael Mauboussin's book More Than You Know. Tellingly, it's the very first chapter of the book, and it opens with this quote from Robert Rubin:

Individual decisions can be badly thought through, and yet be successful, or exceedingly well thought through, but be unsuccessful, because the recognized possibility of failure in fact occurs. But over time, more thoughtful decision-making will lead to better overall results, and more thoughtful decision-making can be encouraged by evaluating decisions on how well they were made rather than on outcome.

Mauboussin emphasizes the point, writing:

... investors often make the critical mistake of assuming that good outcomes are the result of a good process and that bad outcomes imply a bad process. In contrast, the best long-term performers in any probabilistic field -- such as investing, sports-team management, and parimutuel betting -- all emphasize process over outcome.

Winning the process game

Mauboussin very clearly lays out what the ideal goal of any investment process should be:

The goal of an investment process is unambiguous: to identify gaps between a company's stock price and its expected value. Expected value, in turn, is the weighted-average value for a distribution of possible outcomes. You calculate it by multiplying the payoff (i.e., stock price) for a given outcome by the probability that the outcome materializes.

What does this mean in practical terms? I often begin my investment research using a screen that identifies stocks with certain attributes. For our purposes here, let's say I'm looking for stocks that are currently out of favor with investors, so I set a screen looking for any stock that has declined by 20% or more over the past year and is currently trading at less than its tangible book value. Here are a few of the companies that pop up:

Company	Year-Over-Year Price Change	Price-to-Tangible Book Value
Banner Corp (Nasdaq: BANR)	(23.7%)	0.6
K-SEA Transportation Partners(NYSE: KSP)	(61.4%)	0.4
Oilsands Quest (NYSE: BQI)	(59.0%)	0.4
Hercules Offshore (Nasdaq:HERO)	(38.1%)	0.4
American National Insurance(Nasdaq: ANAT)	(26.5%)	0.6

Source: Capital IQ, a Standard & Poor's company.

To follow good process in evaluating these stocks, I'd first try to identify possible outcomes for them, and what those outcomes would mean for the stock price. 

1. Washington-state-based Banner, for instance, traded at more than twice its tangible book value prior to the financial crisis, so we could probably envision a case where shares recover to three or four times their current value. 
2. American National Insurance, meanwhile, has had cyclical valuation swings that have typically put its tangible book value multiple in a range of 0.5 to just above 1.0. In a scenario where toxic assets don't eat away at the balance sheet and investment returns start to increase, investors could see real upside here, too.
3. Of course, we also need to consider negative outcomes, as well. For example, investors would want to note that Oilsands Quest has never reported an annual profit. There may be a huge upside if the company finds a way to profitability, but its assets may not be worth all that much if it can only produce losses. 
4. Similarly, driller Hercules Offshore has been trying to find its footing again, but the need for a balance-sheet-strengthening capital raise may impact the value of currently outstanding shares.

Once you have a list of the potential outcomes for the stock in question, you can then weigh the potential for each of those outcomes to come to fruition, and end up with a good sense of whether the stock is a worthwhile investment.

http://www.fool.com/investing/general/2011/01/11/this-is-more-important-than-investment-profits.aspx

**A Seven-Step Process for investing in New Assets

Advice for investment accumulators
By Christopher M. Flanagan, J.D.

Published January 1998

React to this article in the Discussion Forum.


Frequently, people make investment decisions based not so much on what they know or what their experiences have been but, rather, on how they acquire assets. In other words, how investors build their portfolios often is driven by how they acquire their investable cash. For example, one might be a partner in a medical or law firm and receive a partnership distribution. Or, perhaps he or she is a corporate executive who receives a yearly bonus. In either case, assets are received in stages or "chunks," and the individual must now determine an investment route for these new assets. The result of this piecemeal approach now is a collection or accumulation of investments. It is a difficult process if you have a goal of being consistent with an overall plan.


A Flawed Investment Process

After receiving that Christmas bonus, or perhaps liquidating part of a business, the accumulator’s investment process typically takes the following path. First, current market trends are considered, e.g., "Blue chip stocks seem to be doing well," or "There are global opportunities, but market volatility is a concern." Ideas are then checked with a knowledgeable person whom the investor respects (stockbroker or relative). Next, the investor reviews his or her current portfolio and considers whether to add to existing investments, e.g., "I might want to add money to my common stock fund." Finally, the money is invested. The process appears logical to the accumulator, but it is flawed in that it typically takes into account only "this year’s" money and not all of the investor’s assets. The result is a collection of investments, rather than a portfolio with a comprehensive strategy.


A Seven-Step Process


While everyone’s situation is unique and financial needs can be met and addressed in a multitude of ways, the process for identifying what those needs are revolves around the same fundamental issues. At the risk of oversimplification, applying the following seven-step process would enable the accumulator to make smarter investment decisions for the long-term and not just for the moment.


Establish an investment goal. Establishing investment goals amounts basically to writing down, in language someone else would understand, one’s personal investment goals. It can be in very general terms, such as "I want to have enough money for a comfortable retirement," or "I want to make sure I can put three children through college," or perhaps, "I never want to run out of money." That’s pretty plain language, but it certainly does the job of identifying an individual’s financial ambitions and concerns.


Determine the ability to tolerate investment risk. Understanding how much risk someone can tolerate is a very personal thing, but one rule of thumb can help an individual know when they’ve exceeded that comfortable level. Again, it is a basic guideline, but one should "never own any investment that will cause you to lose even five minutes’ sleep at night." Investors frequently ignore this guideline in an "up" market.


Calculate the annual return objective: what kind of performance do you need to get from your investments. The next step is to calculate the average annual return the investor needs or wants, and there are a couple of ways to do this. Begin by looking back at the personal investment goals. As an example, let’s use the goal of a college education for three children. If an individual needs $100,000 a year in today’s dollars—and knowing how much he or she has today and how much will be put aside going forward—you can go through the mathematical calculations of figuring out exactly what annual return on the money is needed to reach the goal. The individual can then get a sense for whether his or her expectations are realistic and whether he or she is setting enough aside to invest for future use. Another method is to take a look at the historical performance data, not over a one-year period, but over a ten-, thirty-, and fifty-year period. Studying long-term performance results will help to keep in line the investor’s expectations for future returns.


Select asset allocation among types of investment vehicles. The next step is determining the asset allocation that best meets investment objectives. Arguably, this is the most critical step and one where individuals could benefit from some professional advice. Asset allocation, the buzz words in financial services today, is how assets are apportioned among various asset classes (stocks, bonds, etc.). The goal is to achieve the highest return at a risk level the investor is comfortable with. Achieving the highest return for any given level of risk is an efficient portfolio mix. Generally speaking, we know that between 65 percent and 85 percent of a portfolio’s performance will be dictated by the structure of the portfolio—the mix of asset classes—rather than the specific individual investments that are held within it. Consequently, it is more important to figure out what portion of a portfolio should be in stocks, etc., rather than which stocks to select. Here is where someone might call on expert assistance. Chart first how much risk exists in the current portfolio (it is often more than expected). Next, determine if it is possible to increase potential returns without increasing your risk and identify the ideal mix of investment types, (stocks, bonds, etc.) necessary to accomplish this.


Choose specific investments. Based on the investment types identified, it is now time to choose the specific investments that are most appropriate. This is where most of the investment "clutter" happens: comparing which stocks did better than others, which funds outperformed benchmarks, etc. And it is here that one needs to have a well-diversified portfolio. Once again, though, while investment selection undeniably impacts the overall performance of a portfolio, it is more important that those investment selections are diversified within the investment types that best support the investor’s long-term investment strategy.


Monitor portfolio performance quarterly. While it isn’t necessary to get mired in every single week’s or month’s worth of statements, it is important to review results on a quarterly basis. Take a hard look at the percentage returns on the entire portfolio during the past quarter. How do those results compare to the annual percentage return objective and to the long-term goal? Were performance expectations met, and were they realistic? Does the investment strategy need to be adjusted?


Revisit steps 1-5 annually. Once a year, walk through the above steps for making smarter decisions. Revisit (perhaps revise) investment goals, as they can and should change over time. With the current appetite for risk in mind, calculate the annual percentage return objectives. Accurately select the asset allocation that will help to meet those goals, and the result will be a successfully structured portfolio.


Ironically, "investment accumulators" usually don’t appreciate how successful they truly are. Because they didn’t inherit their money or win a lottery, but rather just worked for it a little at a time over the years, they don’t think of themselves as "wealthy" or even financially successful. Consequently, they may not be giving their investment portfolio the respect it deserves.


Christopher M. Flanagan, J.D., is a regional manager for Mellon Private Asset Management, a service mark of Mellon Bank Corporation and its subsidiaries.



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