Investing is a game of probabilities. In any game where probability is a factor, luck undoubtedly plays a role. This leads to the age old question of how much of our investing performance is impacted by luck?
Is an investor who has outperformed the market a good investor? Similarly, is an investor who has underperformed the market a lousy investor? The answer is surprisingly complex.
Fooled by randomness
In his book, Fooled by Randomness, Nassim Taleb argues that we tend to misinterpret events as less random than they actually are. In other words, luck is more influential in the outcome of an event than we tend to think. He wrote:
“Past events will always look less random than they were (hindsight bias). I would listen to someone’s discussion of his own past realising that much of what he was saying was just backfit explanations concord ex post by his deluded mind.”
Harsh? Yes, but I can testify that I’ve experienced similar conversations. In a world full of unknowns and wide dispersions of possibilities, luck does play a significant factor in the final outcome. More than we want to believe.
This phenomena of luck and dispersion of outcomes is prominent in investing. Not only are short term stock prices volatile and random, but long-term stock prices are also influenced by luck.
Long term stock prices tend to gravitate toward the present value of the company’s expected future cash flow. However, that future cash flow is influenced by so many factors that result in a range of different possible cash flow possibilities. Not to mention that on rare occasions, the market may grossly misprice certain securities, such as Gamestop. As such, luck invariably plays a role.
Understanding luck
When it comes to investing, we should acknowledge that the future is not certain. There always is a range of different possibilities.
As such, the first thing we need to do is to understand that outcomes do not determine skill or luck.
A good example is that past performances in a fund does not correlate to future good performances. In his book, The Success Equation, Michael Mauboussin wrote:
“I compared excess returns for the three years ending in 2010 with the Morningstar ratings for the funds at the end of 2007… I found a poor correlation (r=-10). The primary reason individuals and institutions invest in a fund is that they liked the way it performed in the past. But those figures give little information about what the fund will do in the next three years.”
What this shows is that luck was perhaps one of the factors that impacted both pass and future returns for those funds that Mauboussin mentioned.
Identifying skill
The next step is disentangling luck and skill. Unfortunately, it’s not so simple. Michael Mauboussin wrote:
“Not everything that matters can be measured and not everything that can be measured matters.”
Skill is one aspect of investing that is hard to quantify. However, there are a few things I look at.
First, we need to analyse a sufficiently long track record. If an investor can outperform his peers for decades rather than just a few years, then the odds of skill playing a factor become significantly higher. Although Warren Buffett may have been lucky in certain investments, no-one can deny that his long-term track record is due to being a skilful investor.
Think of this as going to the casino and playing blackjack. You can go on a lucky winning streak for a night, maybe two or even weeks on end. But imagine going to the casino everyday for years. Luck will eventually catch up to you and your win rate, or rather your loss rate, will gravitate towards the mathematical mean.
Next, focus on the process. Analysing an investment manager’s process is a better way to judge the strategy. One way to see if the manager’s investing insights were correct is to compare his original investment thesis with the eventual outcome of the company. If they matched up, then, the manager may by highly skilled in predicting possibilities and outcomes.
Third, find a larger data set. If your investment strategy is based largely on investing in just a few names, it is difficult to distinguish luck and skill simply because you’v only invested in such few stocks. The sample is too small.
But if you build a diversified portfolio and were right on a wide range of different investments, then skill was more likely involved.
Parting words
Ultimately, our investing success comes down to both skill and luck. But disentangling luck and skill is the tricky bit.
Maubossin wrote:
“One of the main reasons we are poor at untangling skill and luck is that we have a natural tendency to assume that success and failure are caused by skill on the one hand and a lack of skill on the other. But in activities where luck plays a role, such thinking is deeply misguided and leads to faulty conclusions.”
It is important that we understand some of these psychological biases and gravitate toward concrete processes that help us differentiate luck and skill. That’s the key to understanding our own skills and limitations and forming the right conclusions about our investing ability.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.Of all the companies mentioned, I currently have no vested interest in any of them. Holdings are subject to change at any time.