Don't Confuse Good Outcomes With Good Decisions in Investing
In 2004, Ashley Revell doubled his net worth in a matter of seconds by betting his life savings on one spin of a roulette wheel.
Excellent result. Terrible decision.
As a financial adviser, I constantly make recommendations to clients, analyze the decisions they make on their own, and evaluate the advice of other advisers. As I do each of these, I try to avoid the assumption that a good outcome is the result of a good decision or that a bad outcome was due to a bad decision.
Many people struggle with judging whether a decision was good or not, even in hindsight, because they only look at the outcome. In reality, a good choice is defined by the decision-making process, which you should evaluate independent of the eventual results.
When I review a prospective client’s portfolio, I can choose to point out investments that have performed poorly. While this can help land a new client, pointing out these losers isn't necessarily helpful. All portfolios include bad investments from time to time. It's more important to learn why the investor made the decision to invest and how he or she reacted to the loss. In order for the investment to be a bad decision, the drawbacks of the investment had to be known or knowable at the time it was made.
Over the past several years, a portfolio invested solely in the S&P 500 would have outperformed a more diversified portfolio. A portfolio fully invested in Apple stock would have performed even better. But neither of these portfolios would be a good choice, even though they would have achieved good results in the short run.
Different investments serve different roles in a portfolio. If you have held 20% of your portfolio in bonds that have returned next to nothing over the past several years, you’ve done nothing wrong. Those bonds served their purpose: providing stability to your portfolio in the event of a market pullback. Just because the risk never materialized doesn’t mean the insurance wasn’t worth having.
On the other hand, while we never recommend investing in gold, I wouldn’t sell now solely because the price has dropped. Poor performance is a reason to evaluate a past decision, but falling prices can just as easily be a reason to buy an investment as they can be to sell it. As with any investment, you should consider why you owned it in the first place before selling:
- Has your original objective for that investment changed in any way?
- Do you know something now that you didn’t know when you bought it?
- Do you own too much or too little?
- Is there a better investment to achieve your goal?
- If the investment is a fund, was it managed in a way you weren’t expecting?
- Is there a less expensive fund pursuing the same strategy?
If the answer to any of these questions is “yes,” it might be time to sell the investment. But remember: A "yes" doesn't necessarily mean you made a bad decision in the first place.
Good decisions are characterized by thoughtful consideration of the range of potential outcomes, as well as an understanding of how likely each outcome is. Good decisions result from research, understanding, and conscious choices.
In practice, it’s better for a bad decision to yield good results than it is for a good decision to yield bad results. However, a portfolio of good decisions has more future promise than a portfolio full of bad decisions that, thanks to luck, may have done well so far. It's always worth asking yourself if your portfolio contains any bad decisions, regardless of the current results.
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Benjamin Sullivan is a manager at Palisades Hudson Financial Group, where he helps the firm’s high-net-worth clients with their personal financial planning, investment and tax planning needs. He is a certified financial planner certificant and an IRS enrolled agent.