Lucky, or good?

One of the hardest things to do well, especially as an investor, is to learn from our mistakes.

When we pick an investment that does well, it’s easy to think about it, analyze it, dwell on how smart we are. But, when an investment goes against us, it can be very tempting to put those losses into our mental dustbin and try to forget them.

This temptation really should be resisted, because learning from our mistakes is more important than celebrating our victories.

Just as important, and more often overlooked, is that we should examine critically our successes, too. Sometimes good outcomes are due to luck and not skill. We need to understand which occurred to improve our results over time.

I like to look just as hard at my failures and my successes, because learning from both can reveal powerful lessons that can be applied in the future. I’ve found this can lead to much better investment results over time.

There are several questions I ask myself with both successes and mistakes:

  1. What happened at the underlying business in terms of fundamentals?
  2. What happened to the market price and valuation with respect to those fundamentals?
  3. Was I lucky, or good?

(I ask more questions than this, but these are the most important ones.)

When I invest, I do it based on certain assumptions about underlying growth in sales or book value and underlying margins or returns on equity. My first question is to figure out how far off I was in evaluating those underlying fundamentals. Did the company grow faster or slower than I expected? Were the margins higher or lower? What led to those outcomes and how was that different than my expectation?

My first question is about the underlying company separate from the market’s reaction to it. The second question is about how the market reacted to those fundamentals. Sometimes a company does worse than you think it will, but the market’s opinion becomes more favorable than you thought it would. Sometimes a company does better than expected, but the market’s opinion about the business becomes worse.  

The answers to the first two questions helps me answer the third question: was I lucky or good? When a company does much worse than I expect, but the market’s opinion about the company improves, that’s more lucky than good. When a company does much better than expected, but the market’s opinion sours, that’s unlucky.  

It’s very important to differentiate between luck and skill with investing. If you’ve been lucky and don’t identify it as such, you’re likely to repeat that process and see your luck run out. I had a lot of success buying technology companies from 1996-2000 each time prices pulled back temporarily.  That success was more luck than skill, and I ended up paying the price later when that strategy no longer worked.  

It’s also important to differentiate between bad luck and bad skill. If you pick a company that does well, but sell it because the market’s opinion of the company worsens over time, you will likely miss large future gains. A good process may lead to bad results occasionally, but that’s a bad reason to give up on the good process.

Learning from mistakes can be very time consuming, and that puts many people off. You have to go back and look at historical fundamentals over time, you have to look at how the market reacts to those fundamentals, you have to adjust for temporary changes like recessions or transitional industry dynamics, you have to keep track of your initial expectations and how they changed over time. It’s not simply a matter of looking at your returns in a vacuum, but of evaluating your results relative to your expectations, market reactions and alternative options.

I believe the effort is well worth it, though. When you realize you had good luck instead of good skill, you can prevent that process from happening in the future. If you realize you’ve been unlucky and not unskillful, you can keep that process in place to profit when the odds turn your way. 

No one relishes examining bone-head mistakes in detail, or realizing one’s brilliant outcome was luck instead of skill. But if you like improving results over time, the effort is well worth it.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Lucky, or good?

Skill vs. Probability.

Lucky, or good? This question gets asked a lot, but few realize how important it is.

Having just finished Michael Mauboussin’s book, Think Twice, I couldn’t help but reconsider this question across a range of areas.

It turns out to be crucial in sports, business, politics, investing, and even parenting!

The basic issue is that the outcomes we see are one part skill, and one part probability, (i.e. luck). Where we get wrapped around the axle is when we assume that bad luck means bad skill, or, more frequently, that good luck means good skill.

Sports seems like the most obvious example. People assume hot and cold streaks are due to controllable skill, when they’re much more likely due to good and bad luck. A 60% free throw basketball shooter has a 7.8% chance of making 5 in a row; a 40% shooter has a 1% chance of 5 in a row. But, that doesn’t mean that on any given night the 40% shooter won’t shoot better than the 60% shooter. Sorry, that’s just probability.

A better example is the Sports Illustrated jinx. Teams or athletes tend to do worse after they appear on the cover of Sports Illustrated. Luck or skill? They were probably on the cover because they had skill and a streak of good luck. The did worse afterward because they had skill and a streak of bad luck. Fans will probably claim otherwise, but it’s more likely a change in luck than skill.

The same phenomenon occurs in business. Companies and managers that appear on the front of Business Week, Forbes and Fortune tend to under-perform afterward (both their stock and underlying performance metrics). Were they on the cover because they were terribly skillful, or because they had skill and were a bit luckier than average? This doesn’t bode well for Apple, Google or Hewlett Packard that have graced a lot of magazine covers recently.

You can see the same thing in a business’s underlying performance. If a company is shooting the lights on in sales and profits, it’s part luck and part skill. A company with terrible performance may be terrible, but it’s also likely to be partly bad luck. The statistics show that performance tends to regress to the mean over time–the good get worse and the bad get better.

Politics and entertainment are also good examples. Was Bush purely to blame for 9/11 and hurricane Katrina, or was he unlucky? Likely, he was both unlucky and unskillful, but he’s frequently blamed as if it were all bad skill. Same for Obama. Was he unlucky or unskillful to have the housing market meltdown and a giant oil spill in the Gulf of Mexico on his watch? People aren’t very objective in judging politicians and the degree to which luck plays a part, especially when they go into situations with political prejudices.

I’ve found luck and skill even play a part in parenting. If you’re saying “DUH!?” right now, I agree with you. When my almost 3 year old daughter is sick or teething (which I consider luck, not skill on my part), things go worse. This means tantrums galore! When she isn’t sick or teething, things go a lot better. She occasionally even listens to me! My skill is the same (or at least relatively stable), but my results are different because luck plays a part.

No where is this more obvious in my life than with investing. Luck plays a major part in investing because the outcomes are due to so many complex factors. Predicting economic outcomes, weather patterns, competitive dynamics, etc. makes investing a terribly difficult area to separate skill from luck. And yet, both good and bad luck are there along with skill.

That’s why its so important to look at a managers long term record. If he or she does well over the long run but hasn’t done well recently, bad luck is probably playing a part and good luck will eventually come back. On the flip side, a good record doesn’t necessarily mean skill and good luck, it could just be good luck. This burns investors more than anything else in the investing world, and it counts when looking at investing managers as much as specific investments (Apple, anyone?).

Skill or statistics? Lucky or good. You be the judge. But, don’t fool yourself that both good and bad luck aren’t playing a roll. They most certainly are.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.