A Game of Luck and Skill
Talent vs. Chance in Investment Results
Benjamin Graham is widely known throughout the investment community as being the father of value investing. A lesser-known aspect of his investment career involves his long-term, extremely lucrative investment in GEICO. This one investment was so lucrative that it brought him to state that “One lucky break, or one supremely shrewd decision – can we tell them apart? – may count for more than a lifetime of journeyman efforts” (Article). In this quote, Graham contemplates both the impact that one enormously profitable trade can have on an individual’s wealth and the difficulty in distinguishing the impacts of luck and skill in such a success.
Whenever you read a story about a life changing investment in a single stock (see Tesla and the Meme stocks), Graham’s quote and the difficulty in distinguishing between luck and skill should be on your mind. In such instances, the focus tends to be on the outcome that occurred, but not on the range of outcomes that were likely to occur when looking at history. What may be lauded as an amazing success may not have been far from an utter failure at some point in time. This is not to say that all amazing successes in the stock market can be attributed to luck alone, but that you should have in mind the role that luck can play in such successes.
Investing in stocks at its core is an activity that involves both luck and skill. In his book “The Success Equation”, Michael Mauboussin distinguishes between games of luck and skill by asking the question, “can you lose on purpose?”. If you think about investing, it is hard to confidently say yes in the short run. If you had to pick a stock to lose on in mid-2020, you may have picked Hertz, the rental car company that had recently filed for bankruptcy, only to see the stock price skyrocket on heavy retail trading activity. Of course, this is an extreme case, but it highlights the fact that stock prices are set by many types of market participants, often with quite different goals, strategies, and philosophies.
Additionally, games that are heavily influenced by luck exhibit a high degree of mean reversion. Outsized successes or failures are typically followed by results that are closer to the average. Many of the investors who made huge profits anticipating the global financial crisis of 2008 went on to produce middling results over the next decade. Hedge fund manager John Paulson made nearly $15B in 2008 as the housing market collapsed and 3 years later was managing as much as $36B for investors. As Paulson’s returns subsequently fell short of expectations, assets under management fell to $9B in 2019 before Paulson closed his fund (Paulson Quits). Given the high degree of mean reversion exhibited in the stock market, investors who piled into Paulson’s fund after 2008 should have known that the outsized results were unlikely to be repeated.
In games that involve a healthy dose of both luck and skill, the focus must be on process and probabilities. Over time, a skillful process will produce quality results, but you cannot reliably say that in the short run. For example, if you are saving to buy a house within the next year and have the money needed for the down payment invested in the stock market you are taking on an approximately 1 in 5 chance that you will lose some of that money over the next 12 months (Stock Returns Over Different Time Horizons). If you find your dream house in less than 12 months, those chances of being under water are even higher.
In the short run, luck can run rampant, but in the long run, a good process, good habits, and knowing the role that luck plays in investment outcomes will position you for investment success. When aligning your portfolio with your goals, this distinction should always aid your decision making.