Luck impacts our investing much more than we realize. Acknowledging that fact can help improve results.
In most endeavors, there is a direct correlation between effort and results. If you are smart and put in the hard work, you will likely produce positive outcomes.
The stock market doesn’t quite work that way. You can do endless research, study charts, and understand every nuance of the fundamentals but still end up with a negative result. Investors are ultimately banking on a postive but ultimately unpredictable future outcome, and when someone attempts that, luck becomes a significant factor.
Most market participants underestimate the role of luck in their investing, especially when they have good luck. We are much more inclined to attribute positive results to skill and negative results to luck. However, luck is an equal-opportunity force—it works both ways.
It is a mistake to assume that good results indicate sound decision-making. It is equally incorrect to believe that poor results mean bad decisions were made. The quality of your decision-making is not necessarily reflected in your results. Even the best investors can make great decisions and still experience poor outcomes.
A good analogy can be found in poker. In poker, you can execute a perfect strategy and still lose due to the way the cards fall. Conversely, you can play a hand terribly and still win if luck is on your side. This is simply the nature of any endeavor that deals with an uncertain future.
Although luck is an essential element of investing, most investors do not spend much time thinking about it or incorporating it into their approach. Luck, both good and bad, is inevitable. If you fail to appreciate this fact, your decision-making will be suboptimal, and you will struggle to grow and prosper as an investor.
The main problem with good luck is that it can lead to overconfidence, causing us to believe we can replicate a great outcome through sheer willpower. It is easy to ignore the role of luck in an investment when we have spent countless hours analyzing it.
Overconfidence often leads to larger losses when the inevitable bad luck strikes. We are lulled into thinking we can always control the outcome when, in reality, luck is always at play.
Picture two investors years ago looking for a good stock to buy and hold. One buys Apple, and the other buys Enron. At the time, they both conducted extensive research, studied all available information, and felt confident in their choices. One made a fortune, while the other saw their stock go to zero. Was one of these investors more skillful than the other? To what degree was the outcome simply a matter of luck?
That is a trick question because it ignores the power we have to manage an investment as it develops. That is how you deal with luck—you must recognize it and find ways to manage its impact on the investing process.
So how do you deal with luck?
- Acknowledge the prevalence of luck. As you build your nest egg, consider not only what can go right or wrong but also that something completely unexpected may occur. Risk is always present, and there is no way to eliminate it. You will encounter both good and bad luck regularly. If you expect that, you will be a much better position to avoid making poor decisions when the financial media is hyperventilating over whatever the crisis of the day may be.
- Develop strategies to withstand bad luck. One of the key reasons for diversification is to ensure that a streak of bad luck doesn’t wipe you out. The best defense against an unexpected downturn is to avoid disproportionately large positions. This also means you won’t benefit as much from good luck, so it’s a constant battle to find the right balance.Money management is essentially luck management. The goal is to implement a methodology that minimizes the impact of bad luck while maximizing the benefits of good luck. This requires constant vigilance, effort, and sound strategies.
- Focus on factors that have a tangible impact on results. In most cases, money management is more critical than making bold predictions about the future. The only way to improve as an investor is to separate luck from skill and concentrate on the factors that genuinely influence outcomes, such as timing, risk management, and market conditions. If you focus solely on results without analyzing how luck played a role, you won’t fully understand the quality of your investing process.
Beyond analyzing your own investments, another way to improve is by studying the investments of others. Unfortunately, investors tend to highlight their successes and downplay their failures, making it difficult to get a true picture of their decision-making process. Unlike a poker table, where decisions are more transparent, investment results are often obscured. When hearing about a great or terrible investment, evaluate how much of the outcome was due to skill and how much was due to a lucky confluence of events. This analytical approach will help improve your own investing process.
Luck—both good and bad—is a constant companion in investing. The more you recognize and understand it, the better your chances of achieving superior returns.
