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The role of luck in investment

The role of luck in investment
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The role of luck in investment

Highlights

It’s understood that luck plays a huge role in investing to be successful. But most times we either don’t acknowledge the randomness (of luck) or discount the event that favored an outcome from a decision.

It's understood that luck plays a huge role in investing to be successful. But most times we either don't acknowledge the randomness (of luck) or discount the event that favored an outcome from a decision. Taleb, the author of the book "fooled by randomness" argues about the 'alternate histories' - the other things that could've happened just as easy as the visible histories (i.e. noteworthy events) that did.

This happens especially in the field of medicine. The other day, my wife was discussing about a patient being treated suspected for covid-19 purely because she has symptoms of pneumonia. Upon further examination my wife felt that instead of loading the patient up with higher medication of the virus treatment, recommended just the normal dose of anti-biotics till the reports arrived. It turned out to be that her initial diagnosis proved right and the patient began to recover while two days later the result came negative for the virus. But then, the whole scenario could've turned reverse and that could've registered as an alternate history.

Howard Marks finds highly relevant to investing: The fact that a stratagem or action worked - under the circumstances that unfolded - doesn't necessarily prove that the decision behind it was wise. May be what ultimately made the decision a success was a completely unlikely event, something that was just a matter of luck. In that case, that decision - as successful as it turned out to be - may've been unwise and the many other histories that could have happened would've shown the error of the decision.

So, would that conclude that there is no skill involved in the decision making. Not so, but not all good outcomes are generated out of great skill in decision making and vice versa. Marks talking about decision making mentions his learnings from Wharton that the correctness of the decision can't be judged by the outcome. Nevertheless, that's how people assess it. A good decision is one that is optimal at the time it is made, when the future is by definition unknown, one that's a logical, intelligent and informed person would've made under the circumstances as they appear at the time, before the outcome was known.

And this is the reason we need to be cautious about comparing a performance of an investment from the past results. We may not be sure if the great performance is out of skill of the fund manager or just a random luck that favored that investment. How could we differentiate luck from skill in an investment decision? I like the Michael Mauboussin approach at untangling skill and luck.

Investing is a field where both skill and luck are involved, for instance sometimes (though randomly not by design) either to exit or enter an investment involves luck, but if done after an analysis in identifying that particular investment and the possible action item. So, Michael suggests comparing results with a null model that reflects luck, always. Irrespective of the outcome (of good or bad) the question always should be of what we have expected from chance alone? This idea derives from the assessing the validity of hot-hand in sports.

For example, believers assert that a streak of successful shots in basketball occurs because a player who has made her most recent shot is more likely to make her next shot (she has a hot hand). Yet, streaks are not uncommon and are completely consistent with chance. So the issue is not how many shots our player made in a row, it is how many she made compared to what we should expect due to chance alone. When that standard is applied to the empirical data, the hot hand melts away. The same principle applies in business or investing. Always ask what you would expect by chance.

If we could deconstruct the role of chance or luck in an investment philosophy then we could be able to fairly identify the skill involved in the decision making, though only to that instance. The decision maker could be gifted, at times, but may not turn lucky always. The other way to negate the role of luck is through the consistency in the performance, particularly how a fund or investment decision worked over a period of time. I would be interested more in how the fund/investment delivered returns vis-à-vis the market/benchmark, specifically from the point of risk.

(The author is a co-founder of "Wealocity", a wealth management firm and could be reached at knk@wealocity.com)

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