Morgan Housel is out with a great post on the relationship between luck and risk that you really should read.
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.
One of the biggest mistakes investors can make is confusing luck for skill and good decisions. When you’re dealing with probabilities there’s always a chance that an unlikely possibility makes you money.
You get lucky.
But, if that was the outcome you expected, it was risky. And you’ll need a lot more luck if you try to turn that into a winning strategy. Consistently placing bets on low probability outcomes is a great way to go broke.
Seth Klarman had a bit to say about luck in his book, which I left it out of the post from two days ago since it was already getting long. Here he is:
Investment returns for a brief period are, of course, affected by luck. The laws of probability tell us that almost anyone can achieve phenomenal success over any given measurement period. It is the task of those evaluating a money manager to ascertain how much of their past success is due to luck and how much to skill.
Many investors mistakenly choose their money managers the same way they pick horses at the race track. They see who has performed well lately and bet on them. It is helpful to recognize that there are cycles of investment fashion; different investment approaches go into and out of favor, coincident with recent fluctuations in the results obtained by practitioners. If a manager with a good long-term record has a poor recent one, he or she may be specializing in an area that is temporarily out of favor. If so, the returns achieved could regress to their long-term mean as the cycle turns over time; several poor years could certainly be followed by several strong ones.
Klarman’s point is similar to remarks by Howard Marks and others. You can’t determine skill based on one or two years of performance. And I don’t know anyone who compares the risk taken by money managers to achieve one or two years of returns.
To be fair, annual “odds” of success aren’t listed next to annual returns in a fund prospectus (maybe it should be) and no fund manager brags about being the long shot that pulled off an unlikely win. It’s all skillz, right?
So while anyone can get lucky over the course of a year, skill differentiates itself with time. Warren Buffett is skillful. Walter Schloss was skillful. Marks and Klarman are skillful.
They’ve all done it long enough to know their performance is more than “right place, right time.” But their success was not without a little luck (they’re all humble enough to admit it too). Follow the same the process for that long, that often, sometimes it leads to luck.
And sure, maybe they were born into the right family, went to the right school, met the right people, or got the right job. But had they not been smart and gutsy enough to recognize the opportunity and act on it, we wouldn’t be talking about any of them.
Buffett likes to use baseball analogies to explain investing. Standing at home plate with the bat on your shoulders, you only have to wait for the perfect pitch.
There’s no strikeout rule. You can stand there indefinitely waiting. You never have to swing.
Luck might get you to the plate faster than others. It might get you better pitches than others. Dumb luck might even get you a big hit once or twice. And you can claim all of it was skill.
But without actual skill, and work ethic, and guts, you’ll never recognize and hit the perfect pitches (or lucky pitches) consistently enough to string together a long career.
In a 2014 memo, Howard Marks said it best:
…there’s an old saying that provides a better way to put it: “luck is what happens when preparation meets opportunity.” If you prepare through study and practice, work hard and bring your talents to bear, you’ll be positioned to make the most out of opportunities that arise. This way of looking at life is in line with my formulation regarding investment results: performance is what happens when events collide with an existing portfolio.
- Making it Look Easy is Hard Work – A Wealth of Common Sense
- Buybacks & the Instant Gratification of Financial Engineering – F. Martin
- Capex Darlings and the Myth of Long-Termism – L. Hamtil
- Is the US Stock Market Overvalued? Depends on Which Model You Ask – Alpha Architect
- The Power of Detachment – Intelligent Fanatics
- Half Life: The Decay of Knowledge and What to Do About It – Farnam Street
- How Amazon’s Bottomless Appetite Became Corporate America’s Nightmare – Bloomberg
- It’s Going to Take Nearly 400 Years to Transform the Energy System – MIT Tech Review
- Why Do We Love to Quote (and Misquote) Albert Einstein – Aeon