One Simple Trick to Fight This Common Investing Pitfall

Hindsight is 20/20, but hindsight bias can keep you from learning from your mistakes.

Mar 8, 2014 at 10:00AM

As Managing Director and Head of Global Financial Strategies at Credit Suisse, Michael Mauboussin advises clients on valuation and portfolio positioning, capital markets theory, and competitive strategy analysis. He has also authored three books -- Think Twice, The Success Equation, and More Than You Know -- and is an adjunct professor of finance at the Columbia Business School, and chairman of the Board of Trustees at the Santa Fe Institute.

Once you have established an investing process -- Mauboussin's consists of Analysis, Behavior, and Organization -- how do you evaluate its effectiveness? An investing journal can be extremely helpful in providing a realistic look at past investment decisions.

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A transcript follows the video.

Koppenheffer: The process versus outcome that you talk about, that was one of the real "eurekas" that I got from a lot of your work. If those are the tools that you need to build your process, what's the best way to go about evaluating your process, once you have a process in place?

Mauboussin: Extremely difficult, but there are certain things you want to look for. One is that it's something that you can repeat over time; the idea of reliability, that it can be repeated. The second is, you want to make sure that it's economically sound, so we know that it's based on some foundational things that are very good.

Those, to me, are the main things to be looking for. Then you want to keep track of the kinds of decisions you've made, so you can see how effective you've been.

For example, I'm thinking about a stock and I think about probabilities of outcome. I might say, "There's a small chance something good will happen, an average chance not much will happen, and there's a small chance something bad will happen." Do that over time, for lots of different stocks, and keep track. It will give yourself quality feedback about how good you are, and how well-calibrated you are at making those kinds of judgments.

It's a tricky one to answer. I think evaluating processes in investing is a difficult thing to do, but a couple things on reliability, on economics, and keep track and monitor yourself, and give yourself that kind of feedback.

Koppenheffer: Keeping an investing journal would be the kind of thing that would help you out with that.

Mauboussin: An investing journal actually doesn't take much time, but it does take a fair bit of discipline. I think if you do one of these things, it's a little bit disconcerting because you look back in your journal and you start to realize ...

Koppenheffer: You see what you don't want to see!

Mauboussin: Yes. "Could I have believed that before?" Because the natural thing for all of us is that, once the world unfolds in front of us, we have hindsight bias -- which is that we start to believe that we knew what was going to happen with a greater probability than we did.

The second thing that happens is called creeping determinism, which is you start to believe that what happened is the only thing that could have happened. The reason is, you now have the facts, so your mind is quick to put it all together.

Fighting hindsight bias, fighting creeping determinism -- an investment journal is really effective in doing that. Also, as I mentioned before, it helps you understand how well calibrated you are. If you think a high probability event's going to happen, if it happens a lot, then you're pretty well calibrated. But if you say something's only going to happen 20% of the time, it should happen one out of five times.

Keeping track of those kinds of things takes a little bit of discipline. It doesn't take a lot of time or cost, but it takes discipline, and I think it can be extraordinarily helpful.

Matt Koppenheffer has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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