Can you tell right from wrong?

Investing is a very transparent activity. If you’re right, you’re right. If you’re wrong… well, your portfolio will tell you that, too.

The numbers are all there — in black and white (or red, if you’re unlucky). You invested $1,000.

And now? Do you have $1,100 or $900

That’s a win… or a loss. Plain and simple.

Or is it?

The numbers don’t lie… but they don’t tell the whole story.

Sir Donald Bradman, in his final innings, was dismissed for a duck. A failure, right?

And, by extension, Sir Don was clearly a bad batsman.

What? Surely that’s a gross simplification!

And, of course, it is.

That innings, in itself, was a clear failure by any standard. But it doesn’t tell us anything about the bigger picture.

If all you’d seen is Sir Don’s last innings, you’d wonder about the fuss. You wouldn’t know his stratospheric average of 99.94 runs per innings. The high regard in which he’s held. Or the fact his performance was head and shoulders better than anyone before.. Or since.

And so it is with investing. Yes, you’re either $100 better off or $100 worse off on that hypothetical investment, above. But neither is necessarily indicative of your success or failure as an investor.

Let’s say you’ve made another 3 investments, and each doubled. Or halved. Now we’re getting a better picture.

Now add another few, and investigate the results.

But it’s not just the strike rate, of course — it’s what each result does to your portfolio.

Take the guy who gets 15 out of 20 investments right. Most people would say he’s better than the woman who gets only 5 of those right.

But is that true?

Don’t nod too quickly.

What if I told you the guy who was right 15 times managed an average 10% gain, but the woman’s gain was an average of 20% even after a larger number of failures.

As someone once asked, rhetorically, “Do you want to be right, or do want to make money?”

Maybe you like being right more often, and you’re happy to accept a lower return. I wouldn’t advise it, but fair enough.

For the rest of us, what matters is not whether we were right once. Or even how frequently we were right.

What matters is what your investing approach earns you over time. Or, more simply, how much you have compared to how much you started with.

Right, right? Right, wrong? Or wrong, right?

Now, here’s the other thing about being right. Or wrong.

Sometimes, as the saying goes, bad things happen to good people. Or good things happen to bad people.

Sometimes, we don’t get what we deserve.

The same is true of investing, especially when considering your process.

It’s possible to be wrong, but for the right reasons. You can’t foresee every single risk. Or even if you do, you can’t avoid all risks, of you’d never invest at all.

You can’t account for fraud, misadventure or acts of God. Sometimes, even for Warren Buffett, who has the most enviable track record of the lot, bad things happen — even with a good process.

Equally, you can get an investment decision right, even though the process stunk. You might get lucky and receive a takeover offer, even if that wasn’t on your radar. You can buy a shares business, expecting growth to come from one area, and it comes from something completely different. Consider the mining and tech companies whose shareholders got just plain lucky when the companies announced they were investigating cannabis cultivation, and the shares went through the roof.

Show me someone who says that was their hypothesis all along, and I’ll show you a liar.

Often enough, and almost always over the long run, a good process is strongly correlated with investment success.

But over the short term, random chance plays a much greater role in your performance. As it does when considering single investments.

Buffett’s buys have done extraordinarily well. But some have gone bankrupt. In fact, the company he runs — before it became an extraordinarily successful investment conglomerate — was a textile mill he bought. The mill went broke, under Buffett’s ownership, and he has frequently called that purchase a mistake.

I tend to look at investing using a very simple two-by-two matrix. Down one side (the Y axis for the statistically-minded) is ‘Process’ (Good and Bad). Along the bottom (the X axis) is Outcome (again, Good and Bad).

Individual decisions you make are likely to cluster in the ‘Good Process / Good Outcome’ or ‘Bad process / Bad outcome’ quadrants. Some will end in the other two (either a good process that has a bad outcome or a bad process that ends up with a good outcome).

I’ve had investments in all four. Almost every investor has.

The more conservative you are, the more you should aim for moderate wins in the ‘Good Process / Good Outcome’ box.

Some of you who want to take more risk can dabble in the ‘Good Process / Bad Outcome’ box, but only when you’re aiming for a few very large wins to offset the losses. This approach most closely resembles the venture capital space, where a lot of losses are offset by the occasional Facebook, Uber or Airbnb). But if you’re going to play that game, you need to be smart and have a strong stomach. It’s not an approach I’d recommend, other than with a smaller portion of your portfolio (if at all).

But either way, the role of luck in your portfolio diminishes with each investment (in aggregate). Yes, it’s still a factor, but it’s not something you want to rely on.

Foolish takeaway

In the short term, random chance plays a role. In the long term, it’s almost certainly your process that will determine your outcomes.

So don’t celebrate your wins too heartily. But don’t despair over your losses, either. Each will pass, and it’s the aggregate that matters. That can be an uncomfortable truth, as you either seek to rationalise your disappointments, and seek to remain humble in success.

But you must, otherwise you’ll end up learning the wrong lessons. And that can be costly.

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