Survive the Investment Race

The Indianapolis 500 is touted as "The Greatest Spectacle in Racing." And there's a fascinating quote about what it takes to win the big race at the fabled Brickyard: "To finish first, you must first finish."

To me, that means winning is not just about going fast. It's also about survival, because 500 miles is a long haul.

I think this statement also applies to the stock market. You can have a great short-term run, but if you blow up along the way, you still lose. So what must we do to survive the investment race? To find out, I posed some questions to my friend Michael Mauboussin, chief investment strategist at Legg Mason (NYSE: LM) and author of More Than You Know.

The topic is survival of the fittest. I may have been making a bit of a stretch here, but I wanted to get Mauboussin's opinion on what is more important: to be able to make a better assessment of the odds of success, or to be able to make a more accurate assessment of value? The first thing he said was, "I think that they are intimately related to one another." Once again, there is no cut-and-dried answer. As Charlie Munger loves to say, everything is interrelated.

"The idea is to always buy things below expected value," he continued, explaining that expected value has two components -- the probabilities of occurrence and the value of the outcome. "So recognizing both the odds and the value are very important," he said.

Mauboussin went on to say that investors should give a good deal of thought to "asymmetric situations," an example of which will follow. These situations, he said, "become very difficult psychologically."

Let's give Mauboussin the floor for a moment:

There is one example I used in the book that came from Nassim Taleb's wonderful book Fooled by Randomness, where a colleague asked him what he thought the market was going to do. Taleb said he thought the market was going to go up a bit in the next week. His colleague then asked what probability Taleb assigned to this. He said 70%. As it turns out, Taleb was actually short, or betting the market would go down, in his trading book. His colleague asked how that could be.

And now, take note. Here comes the big lesson:

Taleb said he thought there was a 70% chance the market would go up 1% and a 30% chance the market would go down 10%. If you work the math on that, it is obviously a high probability that the market will be up, but the expected value is actually negative in that case. Said differently, if you played this over and over again over time, you would actually lose money. ...

So I don't know if either one of those is more important than the other. I think it is more important to balance both of them, but most important is to consider that asymmetric situations [exist] and recognize that it is not just probability; it is both probabilities and outcomes combined that determine expected value.

Prepare for victory
Mauboussin says that understanding both the odds and the values associated with events are important to surviving and thriving in the stock market. Here are two things he recommends to help us do that.

1. Probabilistic mind-set.
"It is very important to recognize that anytime you make an investment decision, there are a range of outcomes," Mauboussin said. "One error that we see that is made frequently is people become overconfident and believe that they have a good sense of what those outcomes are likely to be, when in reality, the range of possible outcomes is almost always much broader than they perceive. So recognizing that these things happen is important."

Today, I think an excellent example of overconfidence surrounds Google's (Nasdaq: GOOG) online bill-paying service, Checkout. According to most headlines, Google's new product is better and will kill eBay's (Nasdaq: EBAY) PayPal service. I find it very interesting that so many people believe that just because of Google's success, it can unseat the very strong PayPal business. This implies that PayPal will not be able to evolve to deal with the new threat. And that's probably not a good assumption.

2. Think more; act less.
It is well documented that portfolio turnover (how quickly fund managers buy and sell stocks) has increased over time as managers are under the gun to produce returns today, not tomorrow. So I asked Michael: Can the individual investor, with the right mind-set, benefit more from inactivity? Or have we evolved to where individual investors are going to have to consider moving in and out of stocks very quickly because opportunities and returns will come and go so fleetingly?

Michael said he believes "that a longer-term perspective is almost always the most sensible perspective," especially given the substantial transaction and tax costs that go with short-term investing.

He also mentioned the tendency to focus on outcomes more than on process. Here's what he means: "Process is really about being thoughtful, and it's inherent that you take a long-term perspective. And if you get very focused on outcomes, you start to deteriorate, I think in many instances, your decision-making process."

According to Barchart.com, some of the hottest stocks over one month last summer were these:

Company	Monthly Return	Average Volume
InfoSonics (NYSE: IFON)	37.3%	464,110
Empire Resources (NYSE: ERS)	34.0%	476,849
Midway Games (NYSE: MWY)	31.4%	373,144
*Encore Medical	31.0%	618,244

As of July 6, 2006; *since sold to a private-equity group.

Does this mean these companies were great investments? It's hard to say. If the process that was used in making the investment decisions was good, then perhaps -- though we still need to consider the time frame. But if the decision-making process was just speculation, then the outcome could be just luck.

The Foolish final word
"To finish first, you must first finish." That's what I think Mauboussin is stressing when he says to focus on a process of examining the expected values associated with investment opportunities rather than trying to generate outcomes. In fact, I'll let him have the final word on how to survive the investment race:

"[M]any successful people in other probabilistic domains, including sports-team management or gamblers, really do understand that process is what drives [success] and that outcomes, if the process is good, will ultimately take care of themselves over the long haul."

There are more great investing lessons from my interview with Mauboussin on the way, and I highly recommend you read More Than You Know. It's packed full of wisdom that I guarantee will make you a better investor.

Read more in Part 1 of Fool David Meier's interview: "Is It Luck or Skill?"