It’s Best to Be Lucky *and* Good

Jeremy Lin’s emergence as a key player for the New York Knicks is terrific fun in a variety of ways.  We love stories where the underdog becomes a star.  We like to see nice people who work hard succeed, especially when they overcome failure and adversity.  We also like improbable success, and few things seem more improbable than an Asian American point guard from Harvard making it big in the NBA. Even President Obama acknowledges that he has “been on the Jeremy Lin bandwagon for a while.”

Sports can be seen as the ultimate reality show because the seemingly unbelievable happens with regularity.  Lin only got his big break (at his third NBA stop) after everyone in front of him was injured and he had to play. He was helped too in that the Knicks’ offensive system was perfectly suited to his skills (and with Carmelo Anthony back in the line-up, Mike D’Antoni having resigned as coach, and a difficult injury, “Linsanity” may already be over).

Similar stories include Tom Brady being a sixth round draft choice (199^th pick) and then a clipboard-carrying back-up who became a multiple Super Bowl MVP who married a supermodel, but only after Drew Bledsoe was injured and he got a chance to play.  Albert Pujols was a 13th round draft choice who became the best player in baseball. Kurt Warner went from third stringer at Northern Iowa to bagging groceries to the Arena League to finally becoming a Super Bowl winning quarterback and MVP.

The just-concluded NFL Draft, then, like any player evaluation process, is highly uncertain (as every fan knows all too well). For every Peyton Manning there is at least one Ryan Leaf. There has been a surprising amount of analysis done on NFL Draft economics (see here, for example), but this chart from Yale’s Cade Massey tells us pretty much all we need to know.

The chart plots where the top six most awarded (via Pro Bowls) and rewarded (with cash salary) players from each draft were selected (it starts with 2005 and goes back to allow player success to shake itself out). According to Massey, “Draft order explains only 31% of variation in players’ career starts, 22% of free-agent [money], and 9% of pro bowls.” It’s “largely a lottery.” As Derek Thompson pointed out for The Atlantic, Massey’s metrics could be better (he doesn’t normalize the numbers to reflect the difference in pay at various positions, for example), but the big picture should be clear.

In every year except 2005, at least three of the top six players were drafted in the first round and in most years, at least four of the top six landed in the first round. But that also means that nearly half of the best players (again, using Massey’s metrics) were not drafted in the first round.  It is thus reasonably clear that NFL GMs do a pretty good job of evaluating talent in the aggregate but make lots of individual mistakes, no doubt for a wide range of reasons.

This research and the stories above demonstrate both that scouting is highly inexact and that luck plays an important role in athletic success.  We all like to think that our successes are earned and that only our failures are due to luck – bad luck.  But the old expression – it’s better to be lucky than good – is at least partly true.  It’s best to be lucky and good.

Let me be clear.  I am not denigrating the successes of Lin, Brady, Pujols, Warner or the many others who have achieved athletic success largely on account of their talent and hard work. They are all extremely talented and have earned their success. But luck was heavily involved too.

Luck can cut both ways, of course. Ben Roethlisberger was barely recruited before his senior year of high school because he didn’t play quarterback until then.  His high school coach’s son, who was a year older, did (imagine that).  As a consequence, he went to Miami of Ohio rather than a college power and was likely a more tenuous prospect as a result.  Of course, he had less competition there than he would have had at – say – Ohio State, so maybe had he become a Buckeye he never would have made it at all.

And sometimes the luck is just bad.  My younger son was an All-Freshman PAC-10 performer at Cal before a crushing injury changed everything for him.

We all recognize that the outcomes in many activities of life combine both skill and luck and that investing is one of these.  Understanding the relative contributions of luck and skill can help us assess past results and, more importantly, anticipate future results. Indeed, luck (randomness) is a huge factor in investment returns, irrespective of manager.  “Most of the annual variation in [one’s investment] performance is due to luck, not skill,” according to California Institute of Technology professor Bradford Cornell in a view shared by all experts (Nobel laureate Daniel Kahneman talks about it in this video, for example).

As a consequence, in all probabilistic fields, the best performers dwell on process. This is true for great value investors, great poker players, and great athletes. A great hitter focuses upon a good approach, his mechanics, being selective and hitting the ball hard. If he does that – maintains a good process – he will make outs sometimes (even when he hits the ball hard) but the hits will take care of themselves.  Maintaining good process is really hard to do psychologically, emotionally, and organizationally.  But it is absolutely imperative for investment success.

The great investor Seth Klarman, founder of the Baupost Group, makes a terrific insight: “Value investing is at its core the marriage of a contrarian streak and a calculator.” The contrarian streak means that a good money manager must be willing and able to do something different from what the consensus is doing. However, investment success draws a crowd and dilutes future success, meaning that one can never “rest on her laurels.”

The issue is complicated further in that sometimes the consensus is right. If the movie theater is on fire, you should run out the door with everyone else, not in. So adding the calculator part is crucial.  Being a contrarian makes sense only when it leads to a mispricing between fundamentals and expectations. That is a market opportunity.  Finding money managers with that outlook as well as the ability and the psychological strength to execute it well is astonishingly hard.

But there is yet another problem:  a portfolio’s results are largely dictated by overall market performance during the applicable time period.  In other words, the more risk-averse strategies will generate better returns in a difficult market by protecting the downside and the reverse will also tend to be true, that managers with higher risk tolerances will be more likely to succeed during periods of strong market returns.  The conventional method of mitigating this dilemma is to “risk-adjust” the results, comparing nominal returns with volatility, but this approach is uncertain at best in that volatility and risk are hardly the same thing.

Retirees who look to fund income needs out of an investment portfolio (unless only needing to withdraw tiny amounts annually) are relying upon luck to see them through so that they never run out of money.  To this point, an inflation-adjusted 4 percent withdrawal rate has always been “safe” for these purposes but there is good reason to think (most prominently due to the research of my friend Wade Pfau) that 4 percent will be far too high a withdrawal rate for post-2000 retirees.  Yet many retirees and their advisors are content to continue operating with a 4 percent rate.  They are willing to bet that their luck will hold out.  Even if it ultimately does work out, doing so is poor process (and highly dangerous).

As Kahneman notes, the stock market can be “a game of luck,” where winning a few times doesn’t prove you are smart.  The markets simply do not afford enough regularity to be totally (or even largely) learnable.

The world we live in is profoundly complex and is much more difficult for us to navigate than we usually think or assume. As Kahneman put it, “We systematically underestimate the amount of uncertainty to which we’re exposed, and we are wired to underestimate the amount of uncertainty to which we are exposed.” Accordingly, “we create an illusion of the world that is much more orderly than it actually is.”

There is no free lunch.  Stocks aren’t magic.  Even if you hold them a really long time, risk doesn’t disappear.  Retirement planning requires aggressive saving, hedging and insuring risks where appropriate.  It also requires being realistic.  The odds of winning the lottery are too long to justify big risks.  As Paula Hogan says, the key is to be able to transfer wealth across time and contingencies, not to try to create wealth across time and contingencies (by taking big risks).

In what Kahneman calls the “planning fallacy,” our ability even to forecast the future, much less control the future, is extremely limited and is far more limited than we want to believe. In his terrific new book, Thinking, Fast and Slow, Kahneman describes the “planning fallacy” as a corollary to optimism bias (think Lake Wobegon – where all the children are above average) and self-serving bias (where the good stuff is my doing and the bad stuff is always someone else’s fault). Most of us overrate our own capacities and exaggerate our abilities to shape the future.  The planning fallacy is our tendency to underestimate the time, costs, and risks of future actions and at the same time overestimate the benefits thereof.  It’s at least partly why we underestimate bad results. It’s why we think it won’t take us as long to accomplish something as it does. It’s why projects tend to cost more than we expect.  It’s why the results we achieve aren’t as good as we expect.  It’s why I take three trips to Home Depot on Saturdays. We are all susceptible – clients and financial professionals alike (see below).

In a financial context, the planning fallacy has several particular applications, including the following.

1. Because we underestimate risk generally and discount future risk too much, we ought to be particularly skeptical about our various estimates of results and outcomes and ought to consider more carefully the consequences if (when!) things don’t turn out as well as we planned.
2. We should value the benefits of guarantees (when available) more than the benefits of potential.  Accordingly, we should typically be concerned more about the costs of failure than about opportunity costs.  A bird in the hand is worth two in the bush.
3. We should think about tail risk more (Kahneman mentions it here), even though we tend to overrate it when we focus upon it.  For example, is a “safe withdrawal rate” that assumes a 5 percent portfolio failure rate over a 30-year time span (longevity risk anyone?) anything like “safe” when the consequences of failure are so high and our willingness to undervalue such risks is so clear?

Another reason why this planning problem is so acute for advisors is the so-called “authorization imperative.”  Our plans and proposals must be approved by our clients and we have a stake in getting that approval. This dynamic leads to our tendency to understate risk and overstate potential.  Perhaps we see it as easier to get forgiveness than permission or perhaps it’s just a sales pitch.  Or maybe we have convinced ourselves that we’ve got everything covered (confirmation bias!). In any event, despite its strategic benefits, we run the risk of serious misrepresentation.

Similarly, nearly every advisor works with individuals who say they are risk averse to varying degrees, but typically more risk averse than the advisor would like them to be.  Advisors want maximum flexibility after all. The tendency is then to try to convey to or convince the client that not being aggressive enough is a risk too – the risk of not meeting one’s goals.  And indeed, that is a real risk.  But the planning fallacy is another reason not to push that approach too far.

We all want to be Michael Burry.  That starts by not being Wing Chau.  Of course, we can also be both (think John Paulson).

The first principle of investing should be: lay down your safety net. Just like a trapeze artist, if you’ve got a very strong safety net, you can actually do some more adventurous, risky things up on the trapeze.  Thus the goal in any probabilistic endeavor – including investing – is to protect against bad luck and to be positioned to allow for good luck. We can talk about diversification or expected returns or portfolio performance, but really, the right way to think about lifetime investing is simply matching the relative safety of your assets to the urgency of the need in the future.

For Jeremy Lin, NFL general managers and for investors, it’s best to be lucky and good. But if the consequences of being unlucky are dire, it’s best to buy insurance when and where you can efficiently do so. In that way, you can buy your own luck and make sure that you are successful.