Good Decisions Can Have Bad Outcomes (and Vice Versa)

If I’m playing blackjack and I choose to hit on 18, I have made a bad decision. Even if I get a 3 and win a bunch of money on the hand, it was still a bad decision — just one that happened to have a lucky outcome.

Point being: A decision is good or bad based on what was known at the time of the decision, not based on how it turned out. In the context of a card game, this is all fairly obvious. But it trips people up when it comes to investing.

Like card games, investing involves a significant degree of randomness. As a result, it’s not rare for good decisions to have bad outcomes or for bad decisions to have good outcomes. Over the course of your investment career, you will almost surely make some good decisions that turn out poorly — or vice versa.

The problem in investing, however, is that people often evaluate a decision based purely on its outcome, causing them to sometimes “learn” a faulty lesson in the process (the equivalent of “learning” that it’s a good idea to hit on 18 in blackjack).

For instance, it’s a mistake for most people to pick individual stocks, given that doing so usually increases risk and reduces expected return relative to using an index fund. Similarly, it’s a mistake to put money into an actively managed mutual fund just because it’s “hot” right now, given that most actively managed funds underperform their benchmark and given that even actively managed funds with winning track records tend not to continue to win.

But either of those poor decisions could actually turn out very well. Of course, in the short-term that would be a good thing. (Can’t complain about good returns!) But it’s dangerous if it leads a person to conclude that the decision was wise and should be repeated.

Conversely, if you have a portfolio of expensive actively managed funds and you decide to move your money into lower cost investments, you’ve made a smart decision. Even if your old portfolio (the portfolio that you abandoned in favor of a less expensive option) happens to perform well over the immediate future, you wouldn’t want to conclude that the change was a mistake.

Overall point: Be wary of doing something just because it’s worked well for you in the past. And be similarly cautious about avoiding something just because it hasn’t worked well for you in the past.