The individual investor
This time isn’t different
A river of luck runs through investing. A perfectly sound investment decision can easily work out badly for no other reason than bad luck. That’s just the way life is. It’s really luck at work.
A poorly conceived investment decision can work out magnificently for no other reason than good luck. Well, life is strange.
Most luck is stealthy. It just happens to individual stocks in one’s portfolio, almost without you realizing it. When we first buy a stock, we expect great things. Sometimes things work out and sometimes they don’t. When they don’t, we have to ask ourselves why. It could be luck or simply a poor decision. We must distinguish between bad decision making and bad luck.
Once you have decided the bad outcome was largely the result of bad luck, you have to simply accept it and move on. If you decide there was a significant element of bad management, your investment process was faulty, you got sold on a story, you weren’t properly diversified, and so on, you must learn from the experience and not just chalk it up to bad luck.
Thriving on adversity
Take the case of an investor who prudently invested in one of the following: a major pharmaceutical company, a major engineering company, a major bank or a major oil company. The pharmaceutical company’s blockbuster drug has to be withdrawn because of unforeseen terrible side effects. The engineering company is hit with a debilitating foreign bribery scandal. The Bank suffers life threatening write-offs on subprime mortgage loans. The oil company runs into a huge oil spill and is faced with multi-billion-dollar clean-up costs and damage suits. This is bad luck pure and simple.
Typically the stock price takes a major hit. Even the smartest investors occasionally get smacked with investments like this. The key question is how they react. The price has already gone down. A significant paper loss has already been incurred. Should you sell at that point and take your lumps?
The best investors thrive on adversity. You sometimes have to be an optimist to like situations like this. The reality is that situations like this happen all the time. If one takes the long view, they may represent an opportunity. Yes, it’s no fun to suffer a major stock price setback. However, with well-chosen stocks the incidence in any individual portfolio is relatively infrequent.
On the other hand, these kinds of major hits for a company can often result in a significant overreaction in the stock market that drives the prices of the shares well below intrinsic value. One has to be alert that the company’s franchise has not been permanently damaged. But it might represent a buying opportunity.
The point is that luck happens and that is not the end of it. It can have consequences. In that sense, the outcome of the luck, good or bad, may not at all be random. It can depend on how the market reacts to it and how the individual investor reacts to it.
Gamblers’ fallacy and a run of bad luck
Investors must keep in mind the ‘gamblers’ fallacy’. This is the tendency of gamblers on a losing streak to up the ante, to take more risks. That is, they become risk seeking.
There is a serious predicament for the investor who has truly had a run of bad luck (not caused by bad management). First off, they must avoid the temptation to say that lady luck owes them one and take outsized risks. Second, it’s time for a major rethink. Was the bad run truly bad luck or was it also bad management? It’s not a time to become risk seeking and it’s also not a time to give up. It’s probably a time to go back to basics, to invest very conservatively for a while and stabilize the boat.
A run of good luck
Someone has apparently figured out that a fund manager would need to beat the stock market for 36 years before we would know that his performance was based on skill rather than luck! I can’t vouch for the conclusion but I could believe it’s true. What this would mean is that a money manager might have nothing more than average skills and yet beat the market, over say 30 years, because of luck!
Incidentally, the average money manager beats the market until you take into account fees, commissions and expenses. It’s only after these are taken into account that the average money manager is beaten by the market.
It is not unusual for investors to have a lucky streak that lasts fifteen years. This may surprise some, but it is true. In the same vein it would not be unusual to learn from an investor with a five year relatively uninspiring record in the stock market that they feel they just aren’t going to cut it as an investor. The truth may be that they have been working through one of the stock market’s rough patches. Their performance may largely be chalked up to bad luck.
Tapping into a trend
An investor may by some good management but also a substantial dose of good fortune, tap into a trend that extends for a decade or more. I think of the Dot Com boom of the 1990’s or the commodity boom of the 2000’s. The risk is that the investor who has profited handsomely from the trend may come to believe they have succeeded purely through their own skill as an investor.
Another example would be lucking into a style of investing that is in vogue for an extended period of time. Here I think of the ‘one decision’ stocks and the ‘nifty fifty’ from the 1960’s. Jeremy Siegel’s book contains a good look back at the Nifty Fifty stocks whose average P-E ratio in 1972 was over 40. (Siegel, Stocks for the Long Run – The Definitive Guide to Financial Market Returns and Long-Term Investment Strategies. 1998) p105
A final example might be so called value stocks. Academic papers in the 1980s and 1990 claimed to find a positive relationship between stock returns and earnings yields and book value to market price ratios. Thus was born a generation of quants – so called quantitative analysts. It worked for a while because, in part because there might have been an element of truth to it at one time, in part because it was a self-fulfilling prophesy and in part by good fortune and then it stopped working because the world changed.
As with all runs, good and bad, job one of all investors is to avoid a baked-in mindset. When the good times are rolling it is human nature to assume they will go on forever. It is the same with a stretch of bad times. Pushed to explain their view that the good or bad times will go on and on, people will sometimes argue that ‘this time it’s different’.
Some words of wisdom from Sir John Templeton are apt here. He said: “The four most dangerous words in investing are: ‘this time it’s different’” The simple truth is that current market conditions and trends will not persist indefinitely.
Pride goeth before the fall
Over the long haul, the stock market teaches humility. The successful investor must learn to recognize good fortune for what it is and not confuse it with some brilliance on their part. Pride goeth before the fall.
Lucky calls
The same phenomenon occurs with prognosticators, investment advisors and authors. One or two seemingly prescient calls by a market strategist, an economist or academic author can make their reputation. In truth, the prescient call was more a matter of luck than talent. Understanding that helps the investor to take all predictions with a large grain of salt.
Who cares?
We also suffer from what others think of our luck. The investor whose success is ascribed to good luck may feel his talent is unfairly unrecognized. In point of fact, for the investor, it doesn’t matter what others think.
It is only the professional money manager whose career depends on his reputation for skilled investing and the prognosticator who makes his living by his predictions who will want the world to believe they have succeeded by skill rather than by luck.
Conclusion
Investing is a game of skill. But, like almost all games of skill, luck plays a big part – good luck and bad luck. An investor who claims skill-credit for a lucky outcome is in for future trouble. The investor who loses confidence after an unlucky outcome will not do well in the future.
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For readers wishing to dig a little deeper into the subject of investing and luck, take a look at these posts:
Can investors improve their luck?
Experience and becoming a really successful investor
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