Michael Mauboussin’s paper from May 24, 2004 has three parts. First, we will review these three elements, drawing input from successful people in various probabilistic domains. Second, we go from theory to practice and explore the mechanics and nuances of expected value. Finally, we discuss some heuristics and their associated biases to see why we fail to properly calibrate probabilities and outcomes.
Michael Mauboussin: The Right Stuff
Process versus outcome. Long-term success in a probabilistic field requires a disciplined and economic process. Discipline does not mean inflexibility; top practitioners recognize circumstantial changes and continually adapt.
While satisfactory long-term outcomes ultimately define success in probabilistic fields, the best in their class focus on establishing a superior process with the understanding that outcomes take care of themselves. Probabilistic endeavors require a focus on process because, by definition, poor decisions will periodically result in good outcomes, and good decisions will lead to poor outcomes. Exhibit 1 is a simple two-by-two matrix that summarizes this point:
Former Treasury Secretary and Wall Street veteran Robert Rubin emphasized process in a series of commencement addresses:
Any individual decision can be badly thought through, and yet be successful, or exceedingly well thought through, but be unsuccessful, because of 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. (Emphasis added.)
Rubin underscores the important point that how you evaluate the situation shapes your approach. A singular focus on outcomes will accommodate a lot of poor, but temporarily lucky, processes, and may even encourage dishonest behavior. In contrast, focusing on process will lead to satisfactory long-term results while allowing for inevitable, albeit unpleasant, periods of unsatisfactory outcomes. In the introduction to his book The Theory of Poker, professional poker player David Sklansky has this to
Any time you make a bet with the best of it, where the odds are in your favor, you have earned something whether you actually win or lose the bet. By the same token, when you make a bet with the worst of it, where the odds are not in your favor, you have lost something, whether you actually win or lose the bet.
Sklansky draws out the importance of discipline. Note his point that “you have lost something” even on bets that work out (favorable outcome) if the odds are not favorable (poor process). This advice keeps us solidly rooted in the process and allows for some emotional detachment from short-term outcomes. Unfortunately, the investment community currently focuses more than ever on short-term outcomes. In part, this attention to outcomes reflects a shift in emphasis between the profession and the business of investment management. 6 While the profession emphasizes long-time horizons, contrarian strategies, and outperforming an appropriate benchmark, the business dwells on short-term horizons, selling what’s in vogue, and minimizing variation from a benchmark so as to facilitate asset raising.
In short, few investment firms can afford to focus on process. Not surprisingly, the firms that do focus on process deliver some of the best long-term investment results.
Always have favorable odds. Most probabilistic endeavors consist of several opportunities—whether it is pitches for a batter, stocks for the investor, or hands for the poker player. A relatively small percentage of those opportunities have favorable odds. Sifting through financial propositions to find those with favorable odds leads to success in an uncertain world.
In his classic Beat the Dealer, Ed Thorp describes a proper betting strategy under ideal playing conditions (head-to-head with the dealer, counting cards, single deck, etc.). He notes that even under these optimal conditions, the house has the advantage 90.2% of the time. 7 Seeking situations with favorable odds requires substantial diligence, hard work, and patience.