Why my dumb luck was dangerous

“30% returns? I’m not bad at this.”

That was me after my very first investment - a biotechnology fund that jumped shortly after I bought it. Nevermind that I knew precious little about the sector, the speedy gains showed me I was a talented investor in the making.

Except I wasn’t. Thankfully, before I let that initial misplaced confidence (arrogance) ruin the rest of my investing career, my boss gently asked about my thesis, the holdings in the fund, how sensitive the portfolio was to changes in the wider economy, and a few other questions I really should have known the answers to. It wasn’t a dressing down but rather a quiet lesson in humility that I’ll always be grateful for.

What I was guilty of is what former poker pro and decision strategist, Annie Duke, calls “resulting” - one of the most insidious cognitive traps in investing. It describes the common pitfall of assuming a positive result must have come from valuable input (“My gains show how intelligent my investment decision was in the first place”) or a negative result must be down to a flawed process (“My losses show my investment approach is broken”).

Read more

How to pick ‘forever’ stocks

Do I need to get every stock pick right?

How to value a stock (without losing your mind)

In short, resulting is about judging a decision based solely on its outcome. That’s understandable, given the human brain is a pattern-matching machine and would much rather have a simple cause-and-effect narrative than allow room for randomness or multiple interpretations. But, in a world (and stock market) brimming with incomplete information sets and constantly changing storylines, that simplistic way of thinking can do more harm than good.

The reality matrix

Reflecting on my experience, resulting tugged on my vulnerability of being a new investor among some experienced heads and made the most of my relief at not losing money. Was I right? Wrong? I certainly didn’t know but, in my desperately-seeking-validation mind, surely the outcome had to prove I knew something? Objectively, I was firmly in the dumb luck quadrant above and crucially, even with that 30% gain, it hadn’t advanced my knowledge or ability to consistently make good decisions.

Without my mentor stepping in, I was bound to repeat this low-quality, low-energy process, which would inevitably give horrific results eventually.

All of this might ring a few bells for some people and it might even seem obvious. For me, though, the biggest takeaway isn’t in the folly of youth or the hubris of new investors. It’s the opposite. Later in my investing career, whether informed by that first episode or not, I found myself researching every last element of a stock I could think of, drowning in valuation metrics, with spreadsheets full of “what if?” tabs describing the same stock in different inflation environments.

Read more:

The dividend investor’s checklist

Why valuations matter, even in tech

How much do you need to earn to be rich?

I funneled my energy into a mining stock which promptly dropped after the country’s environmental regulations suddenly changed, leaving me squarely in the top-right quadrant. The temptation was to chuck my approach in the bin and start again, or to be more rash and less bookish - after all, what use had the no-stone-unturned strategy delivered?

After a walk around the block and a chat with some cooler heads, I didn’t go back to the drawing board but the whole thing did make me hesitate before my next few investments. What if another unforeseen force were to pull the rug out from under me again?

There was a shed-load more research this time but the end result was underconfidence and lack of conviction.

Most of us will find ourselves somewhere between these two extremes; at times overconfident and underprepared, at others informed to the back teeth but frozen, wary of a surprise. If we’re at either end of the spectrum, though, it’s normally because we’re letting the outcome inform our view of the process when it should be the other way round.

Avoiding the pull of resulting: three steps

• Control the controllables. Every step we take to reduce the effect of resulting is centred around deliberately separating the decision-making process from the final outcome. For me that means looking at the part of the equation we can control: the preparation. Instead of grading your performance based on returns, try to base it on the quality of the research before and during the investment. Sometimes a process scorecard helps, with tick boxes designed to help you follow a consistent process. For example:

- Have I read the financial statements?

- Have I established the investment opportunity?

- Why do I think it offers good value?

At the very least, recording your initial thesis in an investment diary, spreadsheet or post-it stuck to your monitor will do. Articulating clearly what you thought at the time stops the illusion of predictability you might feel later down the line.

• Don’t let the unknown scare you into inaction. An important part of preparation is admitting what you still don’t know. Research is paramount but we’ll never know every last thing about a company and, even if we did, that would tell us nothing about where the stock will move in the short term. We have to be ready for the story to play out and if a thesis just doesn’t work out like you planned, be humble enough admit something went wrong and reassess. That might mean selling up or factoring in that new information and staying put, only you will know which. You’ll learn much more about yourself as an investor in those times than in the quick wins.
• You won’t get all your decisions right, so don’t expect to. The biggest names in tennis and investing don’t even dream of a perfect scorecard and you shouldn’t either. What’s important is you understand where your ideas have worked out and where they haven’t. A useful idea before you’ve hit the buy button is to conduct a ‘pre-mortem’ in which you mentally fast-forward into a future where the stock has failed. Given what you know, what is likely to have caused it? Is that a genuine, glaring risk from the outset? How would you deal with that if it were to happen for real? Again, we’re trying to reduce the weight of the outcome by preparing for a worst-case scenario before it has the chance to crop up.

Ultimately, we should never be patting ourselves on the back too much for a gain or commiserating too much over a loss. Injecting emotion into the process is a surefire way to let objectivity seep out of the process altogether. And if we’re hanging on for a stock to rise to let us know if we’ve done a good job or not, emotion’s probably been in the driving seat for a while.

Important information

When investing, your capital is at risk. The value of your investments, and the income you receive from them, can go down as well as up and you may get back less than you invest. Forecasts aren’t a reliable guide to future results or returns.

Make sure to do your own research on what investments are right for you before investing or consider seeking expert financial advice. Please note that this article is meant for information and does not constitute any financial advice. This is not an offer, recommendation, inducement or invitation to buy, sell, or hold any securities, or to engage in any investment activity or strategy.