Making Decisions in an Uncertain World
The stock market is unpredictable. No matter how much research you have done, there is always an element of uncertainty involved. Despite this, it is a common tendency for people to evaluate the success of their investment decisions based on outcome of the stock market, even though it is impossible to accurately predict these outcomes at the time of decision making.
A bad decision can lead to a good outcome, and vice versa
A bad investment decision, such as placing a large bet on a highly risky asset, may result in a good outcome (e.g. scoring a multi-bagger) by sheer luck. However, the investor may overestimate their influence on outcome which may in turn encourage him/her to continue making risky bets.
Conversely, a sound investment decision can result in unfavourable outcome. For instance, the decision to invest in a (basket of) low cost broad market index fund/ETF could be a prudent move for long-term wealth growth. However, in the short to middle term, the market return could fall short of expectation. If one evaluates their decision based solely on this outcome, it erode the investor's confidence and lead them to abandon their well-considered investment strategy.
We can illustrate this using a investment outcome uncertainty matrix
Despite making a good decision, there is still a possibility of an unfavourable outcome. Likewise, a bad decision may lead to a favourable outcome if one happens to be lucky. Therefore, it is not appropriate to evaluate our investment decisions based on their outcomes.
Improve the quality of your decision
Instead of assessing investment decisions based on their outcomes, we should focus our attention on the decision-making process itself. Investors should be mindful of the reasons behind their decisions and whether they were supported by evidence and logical reasoning. For example, investing in a broad market index is widely regarded as a prudent decision, supported by empirical evidence that has consistently demonstrated positive return over the long term. This positive return is also know as the market risk premium. Logically, this premium arises because investors, by nature, tend to be risk-averse. To incentivise them to assume greater risk, thereby providing the necessary capital for business development, the market reward the investors with a market risk premium.
On the other hand, making a concentrated bet a single stock may not be the sensible thing to do as you are taking on idiosyncratic risk that is not compensated. Empirical studies have also shown that most stock pickers are unable to outperform the market consistently as elaborated in my previous posts here and here.
Even if you made a financially sound decision, things may not always be expected. If you had invested in the US stock market in 2001, your return after 10 years would have trailed the risk free 10 year treasury by 3.18% p.a. Despite being the sensible thing to do to invest in the stock market, the outcome turned out to be bad.
However, we could mitigate the chance of a bad outcome by diversifying our investment. For instance, if we diversified our portfolio to include 1/3 each in the US, Developed ex-US and Emerging Market, your return would have led the US treasury by 1.78% p.a. over the same period.
Sticking to a good decision
Lastly, it
is important to remain disciplined and stay committed to a
well-thought-out investment strategy, particularly during periods of market turbulence as fear and greed can lead one to impulsive and irrational decisions. For instance, if one were to panic and liquidate their stock investments at the height of the global financial crisis, they might have missed the phenomenal growth in the stock market over the subsequent 12 years.
The content shared in this post is just my opinion and should not be taken as financial advice. In fact, you should never take what a random dude shared online as financial advice, no matter how credible they may sound.
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