Building Failure Into Your Process

Annie Duke has taken an interesting road to become a World Series of Poker champion. She was actually studying to receive her PhD in psychology at the University of Pennsylvania when she had a series of anxiety attacks. Duke was a month away from finishing her doctorate when she decided she couldn’t handle the stress. So she moved out west to start over.

While figuring out what to do with her life following this series of events, her brother — a professional poker player — taught her how to play Texas Hold Em. Poker had a calming affect on her anxiety so she started playing regularly and learning the tricks of the trade. Her psychology training came in handy because poker is about reading the other players and how they’ll react under certain situations as much as it is about reading your own cards.

She took author Charles Duhigg through her learning experience in his book Smarter, Faster, Better and what stood out to me was her focus on probabilities and uncertainty:

When Annie started playing poker seriously, it was her brother who sat her down and explained what separated the winners from everyone else. Losers, Howard said, are always looking for certainty at the table. Winners are comfortable admitting to themselves what they don’t know. In fact, knowing what you don’t know is a huge advantage — something that can be used against other players. When Annie would call Howard and complain that she had lost, had suffered bad luck, that the cards had gone against her, he would tell her to stop whining. “Have you considered that you might be the idiot at the table who’s looking for certainty?” he asked.

She is aware there’s a lot she can’t predict. But if she played this same hand one hundred times, she would probably end up $1,000 richer. So the expert makes the bet and stays in the game. She knows, from a probabilistic standpoint, it will pay off over time. It doesn’t matter that this hand is uncertain. What matters is committing to odds that pay off in the long run. “Most players are obsessed with finding the certainty on the table, and it colors their choices,” Annie’s brother told her. “Being a great player means embracing uncertainty. As long as you’re okay with uncertainty, you can make the odds work for you.”

Learning to accept uncertainty and understand how important it is to use probabilities to your advantage propelled Duke to the top of the poker world. Not only was she comfortable with uncertainty, but she was comfortable with failure.

People seem to assume that an event with an 80% probability of occurring must mean it’s nearly a sure thing. But what it really means is that, on average, you should expect a favorable outcome four out of five times and an unfavorable outcome one out of five times. The people who are able to deal with that one out of five and accept its inevitability are the ones who can handle the pressure when things go against them.

In his book, Drive: The Surprising Truth About What Motivates UsDaniel Pink shows how accepting failure can lead to better results in the scientific community as well:

In one 2009 study, MIT’s Pierre Azoulay and his colleagues compared two different ways to incentivize creativity in the sciences. They examined scientists who received grants from the U.S. National Institute of Health (NIH), which emphasizes external controls such as “short review cycles, pre-defined deliverables, and renewal policies unforgiving of failure.” Then they looked at scientists at the Howard Hughes Medical Institute (HHMI), whose funding process “tolerates early failure, rewards long-term success, and gives its appointees great freedom to experiment.” The result? HHMI investigators produced high-impact papers at a much higher rates than their similarly accomplished NIH counterparts.

One organization tries to ensure certainty and do away with failure while the other embraces failure and learns to deal with it. HHMI has failure baked into their research process because it’s a natural outcome when performing these types of experiments.

Building failure into your process is a rational thing to do. Assuming that you’re never going to fail or going all-in with 100% certainty about anything is a recipe for an even larger failure. You’ll end up compounding mistakes by overreacting because you didn’t plan for a poor outcome.

Think about some of the most well known investment strategies out there — they all have to fail in order to succeed.

Investors with a truly diversified portfolio are always going to hate something that they own. Buy and hold investors in the stock market know that they are going to experience drawdowns. Venture capitalists typically look for a couple of grand slam investments, but could see upwards of 80-90% of their investments fail or produce little-to-no returns. Great traders place stops on their trades because they know they aren’t going to be able to get every single call correct. Trend-followers have to deal with the reality that they will occasionally get whipsawed by buying and selling at the wrong time. Value stocks can always get cheaper. Momentum strategies can see vicious reversals.

The point is that you should always understand these things going into any investment strategy. Some of the most brilliant people in the investment business fail in the markets because they shoot for certainty in their forecasts or try to create the perfect, optimized portfolio. These things don’t actually exist. You have to go into the markets with your eyes wide open and understand that even the very best strategies will let you down at times.

Everyone is wrong at some point when investing. The best you can do is to plan for a wide range of outcomes and make high probability decisions. Learning how to accept short-term failure is actually a good way to avoid long-term failure.

Drive: The Surprising Truth About What Motivates Us
Smarter, Better, Faster: The Secrets of Being Productive in Life and Business

Further Reading:
Buy Side vs. Sell Side

Here’s the stuff I’ve been reading this week:

  • Idea of the week: A moving average scale (Bason)
  • “Wall Street operators commence their career as bulls, and finish it as bears.” (Irrelevant Investor)
  • The job security of a great advisor (Reformed Broker)
  • The black swan siren song (Pension Partners)
  • How one firm uses active management in foreign stocks (Gordian)
  • Why is active management failing? (Big Picture)
  • Trusting an advisor costs money, but lowers stress (Alpha Architect)
  • Don’t get “should” mixed up with “is” (Farnam Street)
  • History lesson: Kahneman & Tversky on heuristics & biases (Judgement Under Uncertainty)
  • 5 best SNL skits about money (Money)
  • This is really cool — type in your zip code to see the change in house prices in your area since 2004 (WaPo)

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