I feel bad when I see young investors lose money into hype assets. Then I remember that it’s better to be humbled early on when a portfolio is small.
Otherwise, speculative behavior may destroy a portfolio worth several decades of income later in life. Most people can only learn from emotional pain brought upon by their own failures.
A good outcome doesn’t always reflect a good decision and vice versa. Luck is the difference between the quality of the decision and the quality of the outcome.
Good outcomes can reinforce the initial behavior, even if the decision was a poor one. A lucky outcome based on a bad decision waters the seeds of overconfidence.
This post will focus on the difference between decisions and outcomes. Finally, we will cover what defines a good decision. But, let’s first start with the biological basis for learning.
Biological Basis for Learning – Good Outcomes
Your brain releases dopamine when you have a nice result. It makes you feel good, and it tells your hippocampus to remember the behavior that led to the good outcome.
Not only do you remember the behavior, but you also remember the “trigger” conditions for which the behavior occurred. Here is the process:
Trigger => Behavior => Pleasure => Remember => Repeat
Examples of the dopamine system in action:
- Take Break (Trigger)
- Smoke Cigarette (Behavior)
- Pleasure (Dopamine)
- Remember the Break (Trigger) and the Cigarette (Behavior).
- Drive Past Casino (Trigger)
- Gamble (Behavior)
- Win Money (Lucky Outcome)
- Pleasure (Dopamine)
- Reinforce Behavior (Learn).
How a Lucky Outcome can Reinforce Poor Decision Making
Now, let’s look at what happens when you make a poor decision and have a lucky outcome.
- See hype around a stock or asset (Trigger)
- Invest large fraction of your wealth in hype stock (Behavior)
- Hype stock goes up, you sell high (Lucky Outcome)
- Pleasure (Dopamine)
- Reinforce behavior (Learn)
- Repeat. Attribute win to your “skill”.
Outcomes Vs. Decisions
A bad decision can result in a good outcome due to good luck. Conversely, a great decision can result in a poor outcome due to bad luck. You can see how this applies to short-term investment outcomes.
A bad decision, if repeated, is expected to lead to a bad outcome. And a good decision, if repeated, is expected to lead to a good outcome. Repeatability reduces the role of luck, and aligns the decision with the expected outcome.
An Expected Outcome - Example
Consider a bet on a coin flip. You win $50 if you flip heads, but you lose $100 if you flip tails. Like all coins, the coin has a 50% chance of heads and a 50% chance of tails.
Your expected outcome is: ($50)(50%) + (-$100)(50%) = -$25. You have an expected outcome of a $25 loss per flip. Engaging in this coin toss is a bad decision if you want to increase your wealth.
You could get 5 heads in a row and win $250 – a better-than-expected outcome due to good luck. Or you may get 5 tails in a row and lose $500 – a worse than expected outcome due to bad luck.
The contribution of luck will reduce as the number of trials increases. If you repeat the coin 10,000 times, you’ll almost certainly end up with the expected outcome of a $25 loss per toss, or $250,000.
Bad Decisions With Good Outcomes
Here are some examples of bad decisions with lucky outcomes.
- You go to the Casino and throw 80% of your life savings on blackjack. You double your money. Great outcome. Terrible decision.
- You put 70% of your portfolio in Bitcoin in August 2020 after seeing great returns and feeling FOMO. Great short-term outcome. Bad decision.
- 100% of your savings are invested in the stock market and you need your money in 3 years to buy a house, and In that time, the market goes up by 40%. Good outcome, bad decision.
- You consistently buy lottery tickets to hopefully increase your wealth. You win the jackpot. Bad decision, good outcome.
Good Decisions With Bad Outcomes
Good decisions, when repeated, will likely result in a good outcome. Here are examples of good decisions:
- You just start investing in 2007, and put your money in an index fund. The market crashes over 40% over the next year. Good decision, bad outcome.
- You receive a $50,000 inheritance and you do research on lump sum investing versus dollar cost averaging. You find that lump sum investing outperforms DCA over 60% of the time. And you have a good understanding of your cognitive biases and your unique risk tolerance. So, you decide that lump sum investing is best for you. However, the market crashes 30% the next 6 months after investing. Good decision. Bad short-term outcome.
- You continue to invest in indexed funds while your friends invest in hype assets. They are growing their money much faster than you in the short term. Good decision, bad short term outcome.
Overconfidence is Reinforced
The combo of bad decisions and lucky investment returns can fortify your natural overconfidence bias. More overconfidence means more bad decisions. This bias is especially strong for young men. I know this from experience.
When outcomes are good we over-weight skills and abilities. Obviously investing in TSLA at the bottom of the COVID crash was 100% skill-based, right? We tend to underestimate the role of luck in these cases.
When we have a bad outcome, we over-weight bad luck and tend to shift blame from ourselves. We tend to over-weight factors outside of our control to explain bad outcomes. This keeps our ego afloat, but it comes at the cost of overconfidence and a missed opportunity for personal growth.
A good outcome based on a bad decision will reinforce overconfidence. This is a rough road because overconfidence becomes more dangerous as our portfolio grows in size.
The Recent Bull Market and Over Confidence
You, like myself, may have started investing in the 2010s. We have seen unreal returns, far above average. We lived through one of the largest bull markets in U.S history. We missed the pain of the dot com crash and 2008 crash. Our only crash was during the first COVID wave where the quick rebound was relatively painless.
Overconfidence peaks at the end of a strong bull market, at exactly the time when expected future returns are lower due to high valuations. The last decade of investment returns can breed overconfidence. I am worried that this has caused many to take on way more risk than they can tolerate.
What is a Good Decision?
Bloggins has an investment time horizon of 25 years, expects a stable military pension, and has a high awareness of his human biases.
Joe has a time horizon of 5 years, expects no pension and doesn’t have much earnings power (human capital). In addition, Joe doesn’t like volatility and values stability.
Investing in 100% stocks is a good decision for Bloggins. But it’s a terrible decision for Joe. They have different goals. In this case I don’t even account for differing values.
The Role of Cognitive Bias
Us humans have many of cognitive biases. Understanding these biases, and how they affect you, will help you make better investment decisions. This will help you take on an appropriate level of risk through proper asset allocation. To learn more, check out my post on common cognitive biases, risk tolerance and asset allocation.
A good decision is not always equal a good outcome and vice versa. Huge investment returns – a lucky outcome – based on poor decisions can fuel overconfidence. This facilitates more poor decisions, which can result in lower future returns, and even significant losses later in one’s investment career.
Losing money early on in your investment journey may help you get in tune with your cognitive biases. It’s a blessing to be humbled early in your investment career.
As always, an understanding of your weak points and knowledge of self will help you preserve and grow wealth over time.