I am sure I have bored plenty of people in recent years by repeating the mantra ‘process over outcomes’. There is probably no more important frame or model to apply when considering how we make investment decisions. In an environment where skill is often overwhelmed by luck and randomness the more we focus on results alone, the worse our results are likely to be.

Drawing a strong and consistent link between process and outcomes is critical to making good judgements, but it is not everything. There is a third element that is often lost or obscured, but should be the starting point for any investor:

What do we believe about investing?

This seems to be an incredibly simple concept, but a clear sense of the investment beliefs that inform our actions is so often lacking. Without this it is almost impossible to assess the validity of an investment process, or gauge whether it is likely to lead to better outcomes.

The Three Parts of an Investment Decision

We can think about investment decisions as being based on three key parts:

Beliefs / Process / Outcomes:

Beliefs: These are the ideas that we hold to be true about investing. They can be broad, or specific to a problem that we are attempting to solve.  

A passive, index fund investor might believe that there is no reasonable means of consistently improving on the returns of the market. An active fund manager with a quality orientated equity strategy might believe that investors underappreciate the persistently high returns on capital from certain types of companies.

These types of beliefs must be the foundation of any investment decision.

Process: A process is the actions carried out or the steps designed to link beliefs to outcomes. We start by believing something about markets and then create a process that reflects our beliefs to deliver the desired results.

Outcomes: Outcomes have two distinct forms – at the start and end of an investment decision. At the beginning, outcomes relate to the goals or objectives we have – our investment intentions. At the close, they are the end results – a pure consequence of our beliefs and process.

The ultimate outcomes are the one element that we cannot control; although, ironically, it is the one we spend most of our time obsessing over.

Why do beliefs, process, and outcomes matter?

Without considering beliefs, process, and outcomes it is highly unlikely that we will make good investment decisions. 

It is incredibly common to see investment processes (at times quite complex in nature) that are not supported by any clear investment beliefs. This is odd. Presumably to create a process to make an investment decision, there must be an underpinning belief – or what is the point of the process?

There are two major errors investors make in this regard. First is to mistake an optically rigorous process (complex, lots of steps) for a good one. A process doesn’t exist in a vacuum, it can only be as robust as the beliefs that it is attempting to enact or exploit. Second is when investors focus solely on whether a process has delivered in the past, rather than why it should (or shouldn’t) work.

It is difficult to assess the credibility of a process without understanding the beliefs that support it. This is irrespective of how robust it may appear, or how comforted we might be by the historic results it has generated. A process (or decision) must be founded upon an explicit or implicit set of beliefs.

It is perfectly possible to have an investment process and not realise what the underpinning beliefs are, although I would not recommend it. 

The Problem with Beliefs

Having a set of beliefs supporting our investment decisions doesn’t guarantee success, but it at least gives us a fighting chance. There are, however, some obvious pitfalls:

Beliefs are wrong: Although holding investment beliefs is essential, it does not mean that they will be correct. In fact, we all have investment beliefs now that are likely to prove erroneous (I certainly do). Possessing a set of beliefs should not mean that they are immutable – rather things we believe to be true based on our assessment of the available evidence. We should always be willing to change and adapt; although if our beliefs are shifting too frequently, they probably don’t qualify as beliefs. 

Beliefs are too vague: Some investment beliefs are so vague they don’t really mean anything. We should be able to read or hear someone’s investment beliefs and have a clear idea about what that might mean for the design of a process or the decisions that they will make. Too often this is not the case, so the beliefs are rendered worthless. A vague investment belief is akin to someone being asked whether they are religious and they say “No, but I am spiritual”; it tells us something but nothing specific enough to enlighten.

Beliefs are inconsistent with process: There can often be a disconnect between our stated investment beliefs and the process we adopt. Let’s say there is an active fund manager who believes that a long time horizon is essential to delivering excess returns but has a process that is likely to lead to high short-term turnover in underperforming positions. They do so because they think they will be fired if they trail the market for a sustained period. Although this seems like an incentive misalignment issue, it is also a question of beliefs. In this situation the investment process is designed based on what the fund manager believes is required to keep their job. Investment beliefs are subordinate.

A high quality investment decision must always have a thread linking beliefs, process and outcomes.

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Investors can take huge strides towards better decision making by dialing down the incessant noise of headline performance, and instead focusing on the underlying processes that have led to certain results. But that is not enough. We also need to spend more time thinking about what we believe. Every decision we make says something about our investment beliefs, we should be clear about what they are and why we hold them.