Role of Luck in Investing

The subject of luck in investing is a fascinating one.

MORGAN HOUSEL of Collaborative Fund once commented that luck and risk are the opposite sides of the same coin but we treat them very differently.

Being a fan of his writings, I went through his views on “luck” and decided to reproduce a few them from 2017 to 2020.

*What have you changed your mind about in the last decade? - 2017*

I respect the role of luck more today than I did a decade ago. I used to view successful people as clearly having more intelligence and drive than others. I’ve come to appreciate how much of success is due to luck, not the least of which is being born into a good family in a good country.

It doesn’t take a lot of imagination to see that if Bill Gates were born in Berlin in 1920, his outcome would have been different. The common rebuttal to this is “Luck is what you’re dealt, fate is how you play your cards.” Which is 100% true. But some people are born with a pair of aces. Worse, they never realize it, and go through life thinking everything they have is a product of their own behaviour.

Robert Shiller once said “Your own thoughts are not really your own thoughts. Everything you think is a product of the people you meet and the experiences you’ve had, both of which are largely outside of your control.” It’s one of my favourite quotes, and makes me realize how strong the invisible hand of life is.

*This is the irony of investing: Risk and luck are different sides of the same coin, but we treat one as critically important, and the other like it doesn’t exist – at least for you, when you succeed. - 2018*

Luck is the flip side of risk. You cannot understand one without appreciating the other.

If risk is what happens when you make good decisions but end up with a bad outcome, luck is what happens when you make bad or mediocre decisions but end up with a great outcome. They both happen because the world is too complex to allow 100% of your actions dictate 100% of your outcomes. They are mirrored cousins, driven by the same thing: You are one person in a 7 billion player game, and the accidental impact of other people’s actions can be more consequential than your own.

But experiencing risk makes you recognize that some stuff is out of your control, which is accurate feedback that helps you adjust your strategy. Experiencing luck doesn’t. It generates the opposite feedback: A false feeling that you are in control, because you did something and then got the outcome you wanted. Which is terrible feedback if you’re trying to make good, repeatable long-term decisions.

In investing, a huge amount of effort goes into identifying and managing risk. But so little effort goes into doing the same for luck. Investors hire risk managers; no one wants a luck consultant. Companies are required to disclose risks in their annual reports; they’re not required to disclose lucky breaks that may have led to previous success. There are risk-adjusted returns, never luck-adjusted returns.

*It is easy to assume that wealth and poverty are caused by the choices we make, but it’s even easier to underestimate the role of chance in life. - 2019*

Everyone’s life is a reflection of the experiences they’ve had and the people they’ve met, a lot of which are out of your control and driven by chance. Being born to different families, with different values, in different countries, in different generations, and the luck of who you happen to meet along the way plays a bigger role in outcomes than most people want to admit.

I want you (addressing his new born daughter) to believe in the values and rewards of hard work. But realize that not all success is due to hard work, and not all poverty is due to laziness. Keep this in mind when judging people, including yourself.

*“Easy” makes a good story. It’s short, persuasive, and comforting. But it’s a deceiving story. Everything worthwhile has a cost, so few things worth pursuing are even a shade of easy. It’s prevalent in investing, where competition collides with luck in a way that makes a hard task (outperformance) occasionally look easy. - 2020*

The appearance of “easy” comes in different flavors. Of the few overlooked ones, “Easy” because luck is underappreciated.

Jim Paul and Brendan Moynihan write in their book What I Learned Losing a Million Dollars:

The potential for temporary success by pure luck beguiles people into thinking that trading is a lot easier than it is. The potential for even temporary success doesn’t exist in any other profession.

If you have never trained as a surgeon, the probability of your performing successful brain surgery is zero.

If you have never picked up a violin, your chances of playing successful solo violin in front of the New York Philharmonic are zero.

It is just that trading has this quirk that allows some people to be successful temporarily without true skill or an edge—and that fools people into mistaking luck for skill.

The key here is the overwhelming odds of denial when experiencing luck. Associating success with skill feels amazing. And it feels amazing because you get excited about your ability to repeat it. The thrill of a winning trade is not just the money you make; it’s the money you anticipate you’ll keep making in the future.

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