Infinitely more predictable that Leicester City being crowned the 2015/16 Premier League champions has been the steady flow of stories in the media detailing the wins of a handful of punters who – for whatever reason (though luck or long-engrained habit seem the likeliest candidates) – had backed the team as 5,000-to-1 rank outsiders before the football season began last August.
Here on The Value Perspective, in common with everyone else – except presumably the bookmakers who, after paying out some £20m in total, are reported to be revisiting their policies on long-odds bets – we have taken a lot of pleasure from the good fortune of these happy few. Still, if we said that was our principal reaction to the story, we would not be telling the truth.
Successful 5,000-1 bets make both great headlines and dreadful behavioural finance case-studies in waiting – and for precisely the same reason. Their rarity value. As this BBC piece noted a few months ago, you could have found the same odds on Elvis Presley still being alive, on the Yeti or Loch Ness monster being proved to exist or, more topically, on a dead heat in the upcoming EU referendum.
The trouble is, it is human nature to focus on an outcome – for example, the £25,000 the Leicester fan quoted in the above BBC piece will have made from his £5 stake – rather than the process that led to that outcome. Such as it was in that instance, the process involved a whim and “a few drinks one night on holiday in Newquay last summer”.
There are few areas where this focus on outcome over process is greater than the world of investment. Conventional wisdom suggests a good investment is one where you make money and a bad investment is one where you lose money. The reality is, however, that if you do not understand how the outcome has been achieved, it is very difficult to repeat it if it was good, or to change it if it was not.
All too often, investors focus solely on outcomes at the expense of process. This is understandable – results matter. Results also tend to be black or white and easy to understand, whereas evaluating a process can be far more subjective. What is more, while results may also be easy to measure, they can be a very poor teacher.
A common pitfall for investors is to assume all good outcomes stem from good processes and vice-versa. Yet as Michael Lewis argues in Moneyball, our preferred sporting point of reference, the best long-term performers in any endeavour dependant on probabilities – whether it is investment or sports team management – tend to focus less on results in isolation than on ensuring the process is right.
So, what are we to do as investors? A solid first step is to acknowledge the role that luck plays in all things. Probabilities only express a likelihood something will happen, not of course a guarantee, and so investors need to accept good decisions will sometimes lead to bad outcomes while bad decisions will occasionally lead to a fortuitously good outcome.
Anyone who aspires to more than the latter – in other words, to consistent, long-term returns – will need more than booze-inspired whims. They will need a process that is both repeatable (which, to be fair, a fiver on your favourite team before each season actually is) and rigorous (which, to be honest, a fiver on your favourite team before each season very much is not).
Thus while Leicester’s 5,000-1 outcome has never happened before and, if the bookies do change their long-odds policy, will never happen again, value investing is a hugely powerful process that is able to point to more than 100 years’ worth of history to demonstrate that it outperforms. This long-term track record is what makes the strategy so compelling.
Obviously, value can underperform over shorter time periods – indeed this is what makes it a difficult approach for many investors to adopt – yet such periods are simply too short for the strength of the process to outweigh the impact of pure chance. We invest on a five-year time horizon, however, as we know it is over these longer periods that value investing can really demonstrate its power.