Two and half years ago, Apple stock was selling for around 90 dollars per share. Now it is above 300. If an investor put 75% of his wealth into Apple stock, would that have been a good investment decision? Many people would say so. Just look at the results. More than tripling your investment can’t be bad. The choice of individual investment does not matter for this example. I could have chosen Ford stock, junk bonds, gold bars, or Chinese ceramics. Many different assets appreciated at abnormally high rates over the last several years.
In spite of the success of this investment, I would argue that this was a shortsighted decision that happened to have a fortuitous outcome. Putting 75% of your wealth in a single investment is almost always a poor idea, no matter what happens subsequently. This investor got lucky. In 2011, he might have another great idea and put 75% of his now larger wealth into another investment, and it might not turn out so well. His process for making investment decisions has a fundamental flaw, and sooner or later, the laws of probability are bound to catch up with him and he will likely experience a very bad result.
One should not judge the quality of a process as a result of one event. To make a proper judgment, the multiple decisions need to be tested in all types of market environments. Market cycles last years (the last several cycles took about seven years each) and making a judgment of an event which occurs only during part of a cycle will lead to misleading conclusions.
Most investors don’t think very much about the process they use to make investing decisions and the underlying assumptions that drive that process. They are much more focused on the potential proceeds of their investments. A focus on the process will better arm one when the inevitable downturns occur or things don’t turn out as expected. Good proceeds will result from a sound process. An unsound process will yield random results, sometimes good and sometimes not so good. Learning that your process is flawed at a market bottom is not an enticing proposition.
The financial media are not very helpful in this regard. Whether in television shows, newspaper and magazine articles, Internet blogs, or the latest “secrets of investing” book, the focus never seems to be on the process of making investment decisions. A process focus leads one to ask different questions from those derived from a proceeds focus. For example, a proceeds-focused investor asks what stock he should buy right now. A process-focused investor asks whether buying individual stocks is something he should even be considering. Focusing on the proceeds highlights the immediate present, as if it is the most critical time to make an investment decision. The process-focused investor knows that the decisions made over a lifetime of investing are what determine success and the current time is no more likely than any other to be critical.
This proceeds orientation also pervades the financial industry. Many financial institutions have a vested interest in keeping investors in the dark about the processes they have developed to garner large amounts of investor wealth for themselves. If investors learned how much of their wealth is lost in middleman fees, they would make different decisions. The financial companies appeal to investors’ emotions, rather than their intellect. Promise investors that they will get rich or be free of financial worries as long as they buy XYZ product or service.
What is needed instead is an unbiased, non-self-serving, thorough examination of the investment decision-making process. Why do investors make the mistakes they do? What common investor assumptions are incorrect? What are the important questions that investors should be asking themselves but aren’t? What are the key ingredients to a sound investment decision-making process?
To my knowledge (and I have researched this extensively), there is no single source for this type of information and knowledge. Therefore I have written a book that addresses these and many other questions about how one goes about making wise investing decisions. It is called Cognitive Investing: The Key to Making Better Investment Decisions, and is available at Amazon and bn.com in both hard copy and electronic formats. The introductory chapter of the book is available for free at the Cognitive Investing web site: www.cognitiveinvesting.com.
It is the first step on the path of making better investment decisions, not just better investments.
Cognitive Investing 