• Can the big four banks recent momentum be maintained? Stuart comments he will be looking for signs of diminishing risk and improved performance. Watch here.

Can you lose on purpose?

01092020_Investing luck

Can you lose on purpose?

Despite the best efforts of money managers to apply skill to the stock picking process, the success of any investment will always be driven by both skill and luck. The proportion of skill and luck determining an investment outcome, however, is constantly changing. More accurately, the role luck plays in the success of an investment decision varies, and there will inevitably be times where luck becomes the more dominant factor in the success of an investment.

Michael Mauboussin, one of the clearest, most logical business writers, has devised a simple way to determine whether an activity involves skill: ask whether you are able to lose on purpose. We can think of a spectrum with pure luck determining the outcome on one end, and pure skill at the other end. Any activity can be plotted on the spectrum, depending on the mix of skill and luck that drives the outcome of that activity.

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Source: 25iq.com

Think of a game of chess, where it is definitely possible to lose on purpose. Skill is the key determinant of success when playing chess. No matter how lucky an amateur chess player is, he or she will virtually never beat a chess grand master. In contrast, a game of roulette at the casino is impossible to lose on purpose. Roulette is a game of luck with defined probabilities for success and failure. For this reason, along with the house edge, there are no professional roulette players (although some casino regulars will beg to differ!).

So where does investing fall on this spectrum of luck and skill?

Let’s say that you had to determine a set of criteria for identifying short opportunities, with the aim of finding stocks that are likely to fall dramatically. You might consider businesses with high leverage, a price that implies elevated growth expectations, misleading accounting, and firms in industries experiencing structural headwinds. However, due to the presence of luck, the above criteria is insufficient to guarantee a successful outcome (i.e., the stock falling).

In what forms might luck manifest itself? It could be through either: (i) a change in the underlying business which affects the firm’s value; or (ii) a change in the market sentiment towards the stock, causing a change in what the market is willing to pay for the same business. An investment manager can control neither of these, but must still consider the range of possible outcomes at the outset when making the investment.

Going back to our example of finding short opportunities, it would have been possible to identify candidates that ticked all the boxes of a great short, yet rising markets fuelled by the excess liquidity created by central banks gave these troubled stocks a lifeline. Luck severs the link between skill and the outcome – that is, you can be skilful and have a bad outcome, or you can lack skill and still achieve a good outcome.

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Where investing falls on the luck/skill spectrum changes, depending on the business environment – that is, the general economic environment and sentiment in financial markets – as well as the investing style of the manager. The two are related; the investment style will determine the impact of luck in any given business environment. A short seller will have to fight the rising tide of a bull market, whereas growth and momentum investors will benefit. Similarly, a value investor operating in a “hot” equity market will encounter a paucity of cheap stocks. There will be limited opportunities meeting their investment criteria and they may underperform in protracted bull markets. The fact that the market is willing to ascribe unduly optimistic valuations to companies is out of the manager’s control and is simply bad luck. In other words, the business environments these managers are forced to operate in – conditions governed by the caprice of chance – are not conducive to their particular investment styles generating strong returns.

Notably, there is no way to improve your luck, given that anything done to improve the result can reasonably be considered skill. In investing, where luck most certainly plays a role, it is important to focus on maintaining a good process, rather than on short term outcomes. The investment process is in effect the only thing you can control.

With the potential for luck to buffet an investor’s returns in the short run, grit is a necessary component for investment success. What grit allows you to do is weather the tough periods where luck takes the front seat and investments do not play out as anticipated. If you conduct stock research with diligence, dedication and a sound framework for analysing businesses, over time the effects of luck will wash out and the skill of the money manager will be allowed to shine through.

Where does investing fall on the spectrum of luck and skill? George identifies why it is important to focus on maintaining a good process, rather than on short term outcomes. Click To Tweet
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George joined MGIM in September 2015 as a Research Analyst. Prior to joining MGIM, George was an investment analyst at Private Portfolio Managers where he covered global equities across various industries, using a value investing framework. George’s prior experiences include equities research and investment banking roles at both Citi and Greenhill & Co.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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2 Comments

  1. Given an “active” fund has the ability to change investments based on a given environment,
    why is it that many active funds underperform ETF’s?
    If the “active” fund manager sticks to a pre-defined strategy regardless of the environment is that not “bad” process?
    Especially, when the investor is paying a premium (compared with an ETF) for the active manager to outperform the market.

    • Perhaps the reason for many active funds underperforming is just that, switching strategies and entering/exiting positions because the market environment is perceived to have changed, rather than dutifully seeing out a process. The difficulty is first predicting that a market environment will change and trading ahead of that, and then again predicting when more normal conditions will return and repositioning the portfolio for that event. That’s next to impossible to do and can often lead to chasing the trend.

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