Michael Mauboussin, author of the new book Think Twice: Harnessing the Power of Counterintuition, believes that luck plays a large role in stock investing.
Why does this matter? Because Mauboussin is also the chief investment strategist of Legg Mason Capital Management, the Baltimore-based asset management company. On a recent visit to Fool HQ, Mauboussin said, "When you place investing somewhere on that continuum of all skill and all luck, certainly I would argue there is a dimension of skill. I think that's demonstrable. [But] I think it probably skews more to the luck side than people are willing to admit."
While there may be a fair bit of luck involved, Mauboussin believes that if investors focus on improving their skills by improving their investment process, they can generate better returns more consistently.
Mauboussin gives the following example:
You're sitting at the blackjack table. You're sitting on a 17. You ask for a hit. You get a 4. Great outcome, but if you do that 100 times or 1,000 times you're almost assured to do very poorly. So by looking at the outcome, you really don't know how good the thinking was. In contrast, if you do have a proper process, you play that hand correctly for a long period of time, and you will do well.
So as an investor, if you're looking to match the market's returns, an indexing strategy makes sense. One of the most popular index funds is the Vanguard 500 Index (VFINX), which gives you exposure to megacap companies like ExxonMobil
But what if you're willing to take on the responsibility of picking and managing your own stocks? In Think Twice, Mauboussin attempts to identify different types of situations in which investors find themselves at a crossroads when making an investing decision, understand the science behind them, and provide ideas for decision-making that will lead to positive outcomes.
Mauboussin's thesis is that investors should focus more on process than on outcome, because focusing on the process is the best assurance for obtaining a favorable outcome.
Applying "think twice" to your portfolio
Mauboussin recommends that investors take three concrete steps when making investment decisions. First, he suggests creating an investment decision journal. Buy a notebook, and whenever you make an investment decision, write down the date, why you decided what you did, what you expect to happen, and your reasoning. Mauboussin says that over time, this record will allow you to audit your decisions. "One of the powerful forces [as far as] human biases is the hindsight bias, which is [that] once we know how things unfolded, we think we knew before with much greater probability than we did," he says. "So this counters that. It forces you to think through how you thought about your decisions and evaluate those decisions."
Second, Mauboussin recommends developing a checklist for investing. It should tie in with your objectives and the kinds of investment vehicles you're going to use.
Third, the expert says investors should develop what he calls a "pre-mortem." The idea behind this is that before you make a decision, you should pretend that time has passed and that your decision turned out badly. Then write down why the decision went wrong. Mauboussin says when people think this way, they can identify up to 30% more factors that lead to poor outcomes. Most importantly, the key to this technique is that you haven't actually made the decision yet, so you're in a position to think about it more objectively.
Following this advice can make you a better investor -- even if getting the stellar results you want may take a little luck as well.
Click here to listen to our Motley Fool Conversations podcast with Michael Mauboussin.
Fool contributor Jennifer Schonberger owns shares of Microsoft, but does not own any of the other companies mentioned in this article. Google is a Motley Fool Rule Breakers selection. Apple is a Motley Fool Stock Advisor pick. Motley Fool Options has recommended a diagonal call strategy on Microsoft, which is a Motley Fool Inside Value selection. The Motley Fool owns shares of Legg Mason and has a disclosure policy.