Process vs. Outcome

I began the year with only a handful of holdings: MRVL, MU, NOK, DESP and GOOGL. Recently I sold GOOGL, leaving my portfolio highly concentrated in four stocks.

Although I was confident in the long term prospects for each company, and still believed that they were individually undervalued, I decided it would be more prudent to diversify into a target of 8-10 total holdings to better manage my risk.

I reduced my holdings in MRVL, MU and NOK by 20-40% when the market opened on Thursday morning. Here was the performance of these stocks for the rest of the week (immediately after I sold):

  • MU +13.79%
  • MRVL +11.33%
  • NOK +9.09%
  • S&P 500 Index: +0.99%
  • PHLX Semiconductor Sector Index: +8.03%

Needless to say, the timing was unfortunate. Semiconductors enjoyed some of their largest gains in the decade and NOK was buoyed by fresh signs that the transition to 5G is happening more quickly than anticipated.

The easy lesson here, as one of the foremost intellectual thinkers of our time has put it, would be to "feel the market" - trust my instincts and act on them, regardless of the risk, diversification be damned. But long term, this is a losing strategy, and one that confuses process and outcome.


It is easy to look at an outcome and assume that because the outcome was positive, the steps leading to that outcome must have been correct. But this type of thinking ignores the complexity and ultimate unpredictability of the world: any outcome that occurred was merely one of many possible outcomes, and it might not have been the likeliest.

More dangerously, this type of thinking can instill a false sense of confidence, and mislead us into thinking that we have more control over the world than we really do. Financial history is replete with stories of such hubris causing catastrophic failure. Investors are typically overconfident in estimating the unlikelihood of "rare" events. They are also more likely to attribute favorable outcomes to "skill", and less favorable outcomes to "bad luck", further inflating confidence.

On a personal level, I am guilty of the same behavior. My performance last year was largely due to a concentrated bet on AMD. Since that bet turned out to be correct, and I was equally (if not more) confident in MRVL, why not concentrate in the same way? After all, Charlie Munger only owns three stocks, and look how well he's done. But, again, it's important to remember that just because these positive outcomes occurred doesn't necessarily mean that they were likely. The news doesn't interview all the failed Charlie Mungers of the world.


If outcomes can be misleading in an uncertain world, what is rational? I think you have to look at the process that led to the outcome. Did it make sense? Was it lucky? How risky was the strategy? These are all subjective matters, but still important to think about.

That's not to say that outcome doesn't matter - ultimately, it is the most important thing - but unless the process is "skillful", the outcome is unlikely to be repeated. This is probably why 90% of professional investors fail to beat the market over a long period of time: in the short term, the winners are judged by outcomes that are largely determined by luck or timing, and when their luck runs out or when their style of investing falls out of favor, they underperform. In other words, their processes were probably flawed to begin with.

The investing process that makes sense to me personally is one that minimizes risk with a more "defensive" posture. In The Most Important Thing Illuminated, Howard Marks makes the distinction between "offense" and "defense":

Offense is easy to define. It's the adoption of aggressive tactics and elevated risk in the pursuit of above average gains. But what's defense? Rather than doing the right thing, the defensive investor's main emphasis is on not doing the wrong thing...
While defense may sound like little more than trying to avoid bad outcomes, it's not as negative or non-aspirational as that. Defense actually can be seen as an attempt at higher returns, but more through avoidance of minuses than through the inclusion of pluses, and more through consistent but perhaps moderate progress than through occasional flashes of brilliance.

Heavy concentration and excessive leverage are two examples of offense:

They'll add to returns when they work but prove harmful when they don't: again, the potential for higher highs and lower lows from aggressive tactics. Use enough of them, however, and they can jeopardize your investment survival if things go awry. Defense, on the other hand, can increase your likelihood of being able to get through the tough times and survive long enough to enjoy the eventual payoff from smart investments.

The market is fickle. The world is unpredictable. Nobody is perfect. As trite as these sayings are, how many people invest with these assumptions honestly internalized? How many otherwise intelligent people (Nobel Prize winners included) falsely think "it can't happen to me"?

Everyone has different levels of risk tolerance, and everything involves trade-offs, but one thing is certain: "Because ensuring the ability to survive in adverse circumstances is incompatible with maximizing returns in the good times, investors must choose between the two."¹ For me, these realizations compelled me to diversify my portfolio at exactly the wrong time. But, again for me, it was the right thing to do.

Show Comments