Luck Be a Lady Tonight

The self-serving bias is our tendency to see the good stuff that happens as our doing (“we had a great week of practice, worked really hard and executed on Sunday”) while the bad stuff is rarely our fault (“It just wasn’t our night” or “we simply couldn’t catch a break” or “we would have won if the refereeing hadn’t been so awful”).  Thus desirable results are typically due to our skill and hard work — not luck — while lousy results are outside of our control and frequently the offspring of being unlucky.

Two fine recent books undermine this outlook by (rightly) attributing a surprising amount of what happens to us — both good and bad — to luck.Michael Mauboussin’s most recent book, The Success Equation, seeks to untangle elements of luck and skill in sports, investing and business.  Ed Smith’s Luck considers a number of fields – international finance, war, sports and even his own marriage – to examine how random chance influences the world around us. [Full Disclosure:  I’m very prone to look at things similarly (more here, here and here)].  For example, Mauboussin describes the “paradox of skill” as follows: “As skill improves, performance becomes more consistent, and therefore luck becomes more important.” In investing, therefore, as the population of skilled investors has increased, the variation in skill has narrowed, making luck increasingly important to outcomes. 

Meanwhile, Smith argues that effort and repetition mean a great deal to athletic success, but that innate talent, which cannot be taught, means even more.  Thus practice — even perfect practice — does not make perfect.  Smith’s recounted experience as a cricketer whose career was ended due to the bad luck of injury and misdiagnosis resonated particularly for me since my younger son’s football career suffered a similar fate. 

Of course, randomness explains why the best team or player doesn’t always win, even though the best will win more often.  Being very good merely improves the odds of success.  It doesn’t guarantee it.  Thus there is even some hope for my Padres.  As Smith emphasizes, “[u]ncertainty is a pain to predict, but a joy to follow.” 

Even without reading Mauboussin and Smith, we should all recognize that the outcomes in many activities in life combine elements of both skill and luck. 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, a point to which Mauboussin pays particular attention.

In Major League Baseball, over a 162-game season the best teams win roughly 60 percent of the time.  But over shorter stretches, it’s not unusual to see significant streaks.  My Padres finished well below .500 in 1999 but still won 14 consecutive games at one point, providing fans with a lot of false hope. Since reversion to the mean establishes that the expected value of the whole season is roughly 50:50 (or slightly above or below that level), 60 percent being great means that there is a lot of randomness in baseball.  That idea makes intuitive sense – the difference between ball four and strike three can be tantalizingly small (even if/when the umpire gets the call right); so can the difference between a hit and an out. 

Similarly, 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 (Nobel laureate Daniel Kahneman talks about it in this video, for example). As Kahneman puts 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.”

The efficient markets hypothesis claims that all market outperformance is attributable to luck. But it has been demonstrated, by data and common sense, that there is a component of skill involved. There is a huge difference between saying investing is all luck and saying it has a lot of luck. Warren Buffett isn’t just lucky, he’s good. But it is important to remember that, on the continuum, investing is closer to the luck side (which is why it is so difficult to profit all the time and to succeed when the market is tanking).

As Mauboussin stresses, in all probabilistic fields, the best performers dwell on process. This is true for great value investors, great poker players, and great baseball players. 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 over the long haul.  Maintaining good process is really hard to do psychologically, emotionally, and organizationally.  But it is absolutely imperative for investment success.

As Mauboussin explains, “in activities where luck plays a strong role, the focus must be on process. Where skill dominates, performance is a dependable barometer of progress. But where luck is a stronger force, the link between process and outcome is broken. A good process can lead to a bad outcome some percentage of the time, and a bad process can lead to a good outcome. Since a good process offers the highest probability of a good outcome over time, the emphasis has to be on process.”

The great investor Seth Klarman, founder of the Baupost Group, offers this 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, since investment success draws a crowd and dilutes future success, one can never “rest on her laurels.”  What works today won’t necessarily work tomorrow.

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 Klarman’s insistence upon adding the calculator is crucial.  Being a contrarian makes sense only when it leads to a mispricing between fundamentals and expectations. That is a market opportunity.  Finding managers with that outlook as well as the ability and the psychological strength to execute it well is astonishingly hard.

Everybody – advisors and clients alike, even Mauboussin and Smith – presumably wants the same thing in the end: high relative returns with a minimum number of sleepless nights. Yet randomness means that even the best process will include periods of poor performance and sleepless nights. This kind of uncertainty is hardly “a joy to follow.” We may want luck to be a lady tonight and every night — but it ain’t gonna happen.