Ask Yourselves: Skill or Luck?

Out of so many investors in the financial market, how many of them are truly skilled investors? It is of little wonder that some begin to ponder about the role of luck in our investments.

While there is overwhelming evidence that value investors, in general, do perform much better than the average investor over the long run, there are also several investors who made it ‘big’ by speculating and trading in the short run. Their short-lived successes reinforce the general view that speculation is the fastest way to riches.

It is extremely important for investors to be aware of the role of luck in investing. Without this knowledge, investors are very prone to this psychological pitfall – self-attribution bias. Basically, it is where we attribute successes to our ability and failures to luck.

Kind of sad, isn’t it?

Importance of luck

If you believe that investing is 100% skill, then you may be disappointed to know that luck plays a huge part too. No matter how prepared you are, the investment opportunities that arise are sometimes heavily dependent on luck. While it is very important to be looking in the right places, success is dependent on looking at the right time too.

Value investors seek to beat the market by investing in companies where the probability of success is higher than the probability of failure. Investing can be viewed as a game of chance, the better you are at tilting the odds in your favor, the greater the success it will be.

That said, risk management techniques like diversification and having a focus on dealing with the risk of permanent loss of capital will pay off tremendously. It is often very helpful in analyzing investment potentials in a probabilistic manner. You should put in greater capital if you are 80% sure about a 20% return than one where you are 20% sure about a 20% return. Diversification without this concept in mind is counter-effective to your portfolio.

Investing vs Gambling

Many investors have a misconception of the difference between investing and gambling. After burning their pockets repeatedly, they believe that it takes great luck for someone to be successful in the financial market.

Let us first discuss the difference between gambling and investing. Both can be either extremely different or the same depending on how you approach investing.

The outcome of playing the lottery is almost fully reliant on luck. When you gamble against the casino, it is certain that the odds are heavily stacked against you. Even if the odds of winning a $1m jackpot is 0.0001%, gamblers will continue to visit the casino as long as they believe that there is a possibility of winning.

Honestly, there is little to no chance where you can influence the ultimate outcome. It doesn’t matter the time of the day you go or whether you have slept on the right or left side of the bed, the odds aren’t going to change at all.

Gambling

Majority of the investors in the financial market gamble more than they invest. When they act on stock tips, they gamble that their source of information is trustworthy. When they invest in an IPO because it seems to be hot, they are gambling on their gut feeling. When they attempt to forecast short-term prices using charts and trendlines, they are gambling on the effectiveness of such instruments. Essentially, gamblers are people who places their bets without being able to provide logical reasoning to it.

Value over all

Value investing, on the other hand, aims to increase the certainty of returns and reduce chances of risks to radically improve the chance of ‘winning’. This is the reason why there are legendary value investors such as Warren Buffett, Walter Schloss and Benjamin Graham who can beat the market year after year consistently. It is impossible to be lucky for decades as luck can only bring you so far.

This, however, does not suggest that successful investments are fully dependent on how intelligent you are too. There are so many bright minds who have suffered humiliation in the stock market.

The stock market is one queer place where the amount of success you achieve is not linearly correlated with the amount of effort you put in. Regardless of how smart and skillful you think you are, you are never going to be immune from bad luck and human error. Like all great investors, Warren Buffett has also made his fair share of mistakes and lost billions of dollars too. It does not mean his investment thesis was wrong, but just the market was not in his favor.

How to deal with bad luck?

There are millions of scenarios that can possibly happen, if you would prepare for every scenario, you may end up hoarding cash and steer clear from all forms of investment.

Before you begin your research, you must know that in the piles of information that are available, only a handful matters to a value investor. You must differentiate the substance from the noise.

Next, you must be aware of the aspects of investing that you can control. You can control the price you pay and the companies you choose to invest in. You can also choose not to invest as well. By investing only when you are confident, you reduce the impact of poor luck.

Still worried about how luck can play a part in your portfolio? Don’t fret! We will be exploring deeper into this in the following article.