How Do Skilled Investors Do It?

Sarah F. Roach, Vice President

We’ve all heard sayings about luck, such as “you make your own luck” or “luck is where success meets prepa­ration.”  In this column, I’m going to discuss the nature of luck, how it factors into investing, and the degree to which it can be “managed.”

First of all, what is luck?  Investment commentator Michael Mauboussin defines luck as the component of any situation that is out of your control.  Put differently, luck exists whenever it is reasonably likely for different outcomes to occur given the same inputs; therefore equally-skilled individuals can experience different results simply due to luck.  An example would be hitting streaks in professional baseball:  Only the cream of the crop become major league players, so why don’t all (or even most) major league batters enjoy periodic, long hitting streaks?  The answer is that skill alone is not enough—streaks require skill and luck.  Said differently by Mauboussin, “…not all skilled players have streaks, but all streaks are held by skillful players.”

According to research by professor Daniel Kahneman, skill alone is particularly valuable in rather stable and predictable environments, where there are relatively few moving parts.  Unfortunately, many human endeavors are not especially stable or predictable.  Many aspects of the investing environment, for example, are often unpredictable and volatile, with many moving parts to analyze.  In addition, investing is highly competitive, and there are many skilled participants.  Unskilled participants may experience short-term success due to luck—think about investing in stocks in 1999—but when actual skill is required, their shortcomings are revealed.

So can a skilled investor “manage” luck?  According to Mauboussin, there are some things skilled practitioners in any competitive, unpredictable environment can do to allow luck to be on their side more often.  The first is to understand what’s important and what can be ignored within mountains of data.  The key is to focus on factors that are likely to be both persistent and predictive.  An example would apply to people choosing an investment adviser:  While a one-year track record may be impressive, it is not persistent, and it’s unlikely to be predictive of future performance.  We use a similar approach when analyzing companies for investment.  We focus on measures that tend to be both persistent from one period to the next and indicative of future earnings and growth.

Another factor Mauboussin uses to analyze the effect of luck is an investor’s “process.”  Does the investor use tools and techniques to maximize skill as a determining component that positions him to benefit—more often than to suffer—from factors outside of his control (i.e., luck)?  To quote Mauboussin, “We know that past results are typically an ineffective way to anticipate future results.  But an isolation on process—a manager’s process—might give us better insight.”  You can think of this as the sandbox where an investor chooses to operate.  In our case, we choose to invest in companies whose current prices don’t appear to adequately reflect our analysis of future earnings, prospects and opportunities (often called “value” investing).  We feel that, historically, these are the sorts of investments best positioned to produce good results, in part because unpredictable events are more likely to help than hurt.  This has been one key to our long-term results.