How to Become a Better Investor: 4 Principles Behind Exceptional Investment Decisions

Instead of searching for the next hot investment idea, we should strive to make sustainable, above average investment decisions. Successful investing isn’t based on home-run type bets. It’s based on sound decision making over many years. To do this, we need to develop principles to guide our decisions regardless of the market environment. Since the future is unknown and will not be exactly like the past, we can’t rely on rigid rules to guide us in every situation. Principles, however, can be adapted and applied to all environments.

To become a better investment decision maker, we should focus on process, not outcome. Many investors judge their decisions by how well their choice worked out. If the stock they picked went up, they conclude it was a good decision. If it went down, it was a bad decision. This analysis is misguided. In the short run, luck and randomness dictate many outcomes. We can be right for the wrong reason. For example, winning money at a casino may be viewed as a good decision, but it was actually a bad decision bailed out because luck was in your favor. If you continue to play at the casino, I can guarantee you will end up with a bad outcome. Luck isn’t a sustainable process. Because the process behind this decision is stacked against you (the odds favor the casino), judging your success by one outcome masked the flawed process underneath.

We encounter the same thing as investors. We buy a stock for the wrong reason, and when it goes up, we take credit for the great decision. Except that it wasn’t a great decision. It was just lucky. We constantly confuse luck and randomness with the quality of the underlying decision-making process. We need to focus on the process to make correct decisions. Any one decision may not go the way we want it – that’s just reality. But what we can’t do is judge ourselves based on one-time examples. We need to judge our decisions making by examining the reliability and accuracy of our underlying process.

Investors, like superforecasters, need to build a consistent and rational approach to decision making. Let’s examine how we can apply some of the principles behind Phillip Tetlock’s book, Superforecasting: The Art and Science of Prediction, to the investment world.  

Principle #1: Unpack the question into components. Distinguish as sharply as you can between the known and unknown and leave no assumptions unscrutinized. 1

Investors should also break down any decision into smaller components. By segmenting the decision into manageable parts, we can better understand the underlying fundamentals without being overwhelmed. We can pass judgement on each individual item and build up our understanding. Otherwise, we overcomplicate the situation by trying to comprehend too much at once.

We should separate the critical underlying assumptions for every decision. These are often buried deep and are usually neglected, unless each assumption is identified. Without examining these drivers, we don’t understand our investments. We also need to uncover the unknowns and the resulting risks. By doing this, we can prepare and plan accordingly.

We often fool ourselves into thinking we know more about our stocks then we really do. We focus on headline-type issues – earning per share, top-line growth, news flow, etc. While these play a role in analysis, we need a deep understanding of the company. For example, when thinking about growth, we need to look at what’s driving the growth. What is the incremental ROIC on that growth? Is it profitable growth above the cost of capital? Is it organic or acquisition driven? Funded by operating cash flow or debt/equity issuance? Is it sustainable? Is the growth protected from competition, or will competition compete away the value of that growth?

Principle #2: Adopt the outside view and put the problem into a comparative perspective that downplays its uniqueness and treats it as a special case of a wider class of phenomena. Then adopt the inside view that plays up the uniqueness of the problem.2

Investors should incorporate an outside view when making any decision. Renowned investor Michael Mauboussin states, “The outside view asks if there are similar situations that can provide a statistical basis for making a decision. Rather than seeing a problem as unique, the outside view wants to know if others have faced comparable problems and, if so, what happened. The outside view is an unnatural way to think, precisely because it forces people to set aside all the cherished information they have gathered.”

“An inside view considers a problem by focusing on the specific task and by using information that is close at hand and makes predictions based on that narrow and unique set of inputs. These inputs may include anecdotal evidence and fallacious perceptions. This is the approach that most people use in building models of the future and is indeed common for all forms of planning.”3

We regularly fail to take the outside view and normally focus on the inside view. We just care about the current decision in isolation and neglect all the other previous decisions that share common characteristics. These previous decisions provide valuable information. As Michael mentioned, the inside view traps us by viewing every decision as unique, instead of trying to learn from similar past decisions. Because the inside view is often complicated with bias, anecdotes, and noise, it provides a terrible basis for investment decisions. The more we can take an outside view and learn from other similar decisions, the better we can calibrate the true probability of making a correct decision.

For example, when buying a stock, investors often gravitate to salient but anecdotal evidence. How fast is the company growing? What has the stock price done? What does the market think of this stock? We latch onto these headlines as a foundation for making decisions. The better approach is to go back in history and look at other stocks with the same characteristics and see how those worked out. By doing that, we have a larger sample size to base a decision. The evidence is better supported because there are more examples that cancel out the idiosyncratic, “inside view” effects.

Instead of looking at our investments in isolation, compare them to similar investments in the past. How have they performed over time? Did those investments work out like expected, or were there unexpected changes that negated the fundamental premise of the investment? For example, if we invest in commodity investments, don’t just look at the current investment fundamentals in isolation. Look back and examine how other commodity investments worked out. We will be surprised how few commodity investments, with the same underlying premises, actually worked out as expected for the investor. By comparing our investment to a reference class, we bring in long-term experience and real case studies to help solidify our investment thesis. If we find more disconfirming evidence than we expected, we may not have such a great investment opportunity after all.

Principle #3: Also explore the similarities and differences between your views and those of others—and pay special attention to prediction markets and other methods of extracting wisdom from crowds.4

We should always be looking to challenge our assumptions and beliefs. We can’t know everything, and we often make mental mistakes. By honestly trying to figure out where we go wrong, we can improve our decision making and build better decision-making habits. Ask yourself, “Why am I seeing this as an opportunity when the rest of the market thinks different?” Am I wrong and the market has it correct? How can I find out? What additional research can I do to tilt the odds in my favor?

Markets usually get to the right decision, although there are moments where they spectacularly fail. We need to understand when the conditions exist for each of these scenarios. If we don’t, we will assume we have an informational edge when we are really just overconfident.

We need to seek other investors who disagree with us. This provides us with necessary counterbalance to our own mistakes and flawed reasoning. We can’t do this ourselves. We are too biased to be 100% independent when reviewing our own work and assumptions. We need someone who can provide an educated and independent assessment of our decision. It’s not easy to hear, but criticism is crucial to our success. We need discomfirming evidence. It doesn’t do us any good to talk to someone who already agrees with us. Chances are that both people are making the same reasoning errors or exhibiting the same mental biases.

The solution is simple. Instead of finding people that agree with us, we should seek people that disagree with us. Examine their arguments and try to understand the differences. It’s not easy. There is never definitive proof on either side. The goal of the exercise is to force us to uncover your own mistakes, biases, and misjudgments. Our ego is the biggest impediment to this process. It’s not fun thinking about how we are wrong. Instead of trying to prove how smart we are, we should go into these situations just trying to learn. We will be amazed how much we can grow as an investor when we stop trying to look smart and instead focus on learning.

Principle #4: Express your judgment as precisely as you can, using a finely grained scale of probability.5

All investment decisions are a matter of probability. Investors who think in terms of certainty or act with 100% confidence fail to understand reality. The world is too complex to have perfect information. It’s painful to acknowledge the limits of our understanding, but we can’t fool ourselves into thinking we know more than we really do. Great investors view all decisions along a probability spectrum. Since they know nothing is for certain, they wait until the odds are in their favor to make big investments. If the odds aren’t there, they wait. And wait. And wait. It might take years for compelling investment opportunities to appear. Investors must be exceptionally patient until the markets provide the right opportunities.

We need to frame our decisions as a series of probabilities. For example, we might assign different odds to how fast a company might grow and how profitable they will become. By doing this, it forces us to examine scenarios that we otherwise might neglect. Many investors just concentrate on the scenario they think is the most likely.

The probabilities are never exact and we will never know how close we got on any one particular decision. Applying higher level mathematics or complex algorithms doesn’t help either, as it will just deliver false precision. The critical idea is to force us to go through the thought process of challenging our own beliefs and examining scenarios that we normally would neglect. It will never be a perfect science, because in the short run reality is full of randomness, complexity, and uncertainty. In the long run, principles-based decision making delivers above average investment returns.

Probability based thinking can lead to counter-intuitive investments. For example, investors often view a highly volatile investment as “risky”. If they instead view that investment in terms of different scenarios of risk and reward, they may find an attractive investment. Even if the base scenario implies a high likelihood of a loss, an upside scenario may deliver a gain many multiples of that loss, leading to an asymmetric risk/reward payoff. Even though most investors neglect the opportunity because of the headline “risk”, astute investors can uncover opportunities in their favor by thinking with probabilities.

Notes:

1,2: From Superforecasting: The Art and Science of Prediction by Philip Tetlock and Dan Gardner

3: http://michaelmauboussin.com/excerpts/TTexcerpt.pdf

4,5: From Superforecasting: The Art and Science of Prediction by Philip Tetlock and Dan Gardner