Strategy vs. Outcome By Frank Armstrong December 12, 2002

Investing is a noisy process. In the short term, it is extremely difficult to distinguish between cause and effect. In the longer term, even with the best planning, wide variations in results must be expected. Investors must make decisions in an atmosphere of uncertainty where the outcome cannot be known in advance.

Worse yet, investors face a barrage of conflicting advice and philosophies, each clamoring for attention, competing for scarce investment dollars, offering "proof" of their superiority, and each holding out images of simple and mystical solutions to an enormously complex problem.

As they wrestle with this problem, investors often confuse strategy with outcome. That's one of the most serious and common mistakes that investors make. They will make far better decisions if they separate the two in their minds.

Investment strategy is forward-looking. We develop a strategy because we wish to exert the most possible influence over an outcome not directly under our control. Of course, if you are delusional enough to believe that you can see the future, you don't need a strategy. I've often said that I would give a lot for just one peek at next Friday's Wall Street Journal. Absent that peek, we need a strategy to deal with life's uncertainties.

Investment strategies should be developed from a sound foundation in financial economics, and a comprehensive investment philosophy. The strategy must be tailored to the unique needs of each investor, considering his or her financial position, time horizon, attitude towards risk, and objectives. It must carefully consider both opportunities for gain, and ability to bear loss. The best strategy is the one offering the highest probability of a successful outcome given that we cannot know the future in advance. It follows that the best strategy goes as far as possible to limit the chances of failure - however defined - and takes no more risk than necessary to achieve an acceptable outcome.

Outcomes are only known after the fact. Investment outcomes are generally crystal clear, and can be calculated to infinite decimal places. After the fact, the results are there for all the world to see. It is childishly simple to compare outcomes over any given time frame. This certainty and precision often gives these outcomes additional weight in the investor's thought process.

Enter the devil! The quality of the strategy cannot necessarily be inferred from the results. The next step in the thought process may be to equate the best outcome with the best strategy. They are not the same thing. For instance, suppose last year I took your entire family fortune to Las Vegas, placed it on a red square and won. Am I a genius? My results are better than 99% of the investment advisors on the planet, but are you comfortable with the strategy? Would you hire an advisor that took that type of risk? If you didn't understand the strategy, you might be pretty impressed. You might even recommend your advisor to all of your friends.

There is enough noise, variation, random drift, and dumb luck in the investment process that even a totally brain dead strategy will sometimes produce superior results. Chasing those results rather than putting them into the context of a rational strategy can lead to disaster. Somewhere in the world's markets something "unusual" is always going on. There are always "winners" that took concentrated risks and won big. That's not necessarily genius. Nor is it likely to be consistently repeatable.

We need look no further than tech stocks in the last half of the 1990s. The sector produced great results, but carried immense embedded risks. Investors that confused those results with an appropriate strategy have learned a brutal lesson. Sector investing carries huge risks that have no additional expected returns. This uncompensated risk is foolish to bear when a much lower risk market solution is available.

Conversely, even the most brilliant strategy cannot guarantee continuous stellar results. Diversified portfolios looked pretty anemic from 1995 to 2000 compared to tech stocks. Failure to deliver triple-digit results was interpreted as a failure of strategy. It wasn't until the embedded risks inherent in concentrated positions became manifest that diversification regained respectability in many quarters.

Occasionally an active fund outperforms its index. That doesn't mean that active is superior to passive. It just means that they had a good outcome against the odds. They might have a good outcome next year, too. Each time period is a separate event, and some active funds will always win the losers game. A very few even repeat. But, identifying them in advance is problematic.

Implementing strategy demands a long-term perspective and discipline. The market will not deliver our assumptions year after year just because we adopted a reasonable strategy (or even a great strategy). For instance, we have every reason to believe that a tilt towards small and value makes sense over the long haul. But, with the benefit of 20/20 hindsight, that clearly wasn't the high return formula for the 1990s. Even the belief that stocks should have higher returns than Treasury Bills was challenged by a 17-year period ending in the 1980s where it didn't happen.

Conclusion

Focusing on strategy is the only rational route to success. Outcomes, especially short-term outcomes, contain so much noise that they are almost completely useless as a guide. Whether the short-term results (outcomes) have been good or disappointing, investors must look beyond them to fabricate the best strategy to deal with tomorrow's needs. The knee-jerk comparison of outcomes to strategy confuses luck with genius, and leads to chasing last year's winners in the fruitless hope that tomorrow will be like yesterday. It rarely is.

Holding onto a flawed strategy that happened to have a good outcome, or abandoning a good strategy with disappointing short-term results, stacks the odds against success.

Frank Armstrong, CFP, is the author of Investment Strategies for the 21st Century as well as the investment guide The Informed Investor. He is the President of Investor Solutions, Inc. a fee-only Registered Investment Advisor.