The Role of Luck in Investing

Investing is pretty interesting for me. The reason is that there’s the element of luck involved. And if there’s an element of luck, skill can tilt the odds in your favor.

Do you watch poker? The world series of poker attracts thousands of professional poker players, pitted against each other, every year to win the prize and be known as the best poker player in the world. What amazes me often is that poker is a game of chance to the lay person. But its also a game of skill. If you think that poker is just merely a game of chance, why do the final seats contains the same people every year?

Where am I going with this?

During the 80’s there’s a birth of a popular hypothesis in the field of investing. It is called the Random Walk Hypothesis. It states that market prices are random. So anyone who made money in the stock market was just pure luck. But then, a small group of investors claimed that there are people who continually beat the market, year by year, so they must know something? The Random Walk people updated their hypothesis to what we now know as the Efficient Market Hypothesis.

This Efficient Market Hypothesis became a theory in modern finance and gave birth to tons of investing strategies and destroyed some, that we will talk about.

Technical Analysis destroyed

Technical analysis fell from grace when the theory got published. The experiment took a sample of technical traders using charts and compare their results. What they found out was that, the technical traders was not very consistent. And is safe to assume that the odds of making a technical trade is as good as tossing a coin. From then on, technical analysis got destroyed but the traders now updated their explanations.

They say that charts work, because everything is already priced in, just like the efficient markets tell us. Every information is available and the price we see is the correct price because all people who invest in the market is rational.

But still, we don’t know if a trader is really good or if he’s just lucky. As you can be lucky many times in a row. The Efficient Market Theorist cheered.

Active Management

The next target for world domination was the mutual fund managers. The efficient market theorist claimed that fund managers that use fundamental analysis are just tossing coin. They are just lucky. And they did what they did with the traders. Pick a stock according to your fundamental analysis and let’s see.

The active management again failed. The stock they picked having a great fundamentals didn’t pan out. The efficient market theorist rejoiced and a birth of a new investing strategy was given to the world.

Index Investing

Technical analysis can’t beat the index. Fundamental analysis can’t beat the index. If you do, its just all luck. You can’t beat it for the long term. So why bother? Just buy the index lol. And this became a mandatory in college education in finance. You will spend 4 years in college only to be taught that its useless to even try.

Financial advisors, gurus and any investing nerds now preach the holy grail of investing in the index. Don’t even try. You can’t do it. It can never be done. If someone beat it, its just luck. Don’t waste your time and money of trying to beat the index. It can never be done.

But then… Someone beat it. And has been doing it for quite some time.

The Anomaly

Then came Warren Buffett. Mr. Buffett has been beating the index for 60 consecutive years. Surely, there must be wrong. Or is he the god of luck? Lucky for 60 years straight? Come on. There must be something.

During an interview, when asked what’s the reason for his success, he says “luck”. If you’re thick on the head, you’ll realize that all successful people attribute their success to luck. What you want to do is read between the lines. The reason why all say its because its luck is, what else do you want to answer? “Because I’m good at what I do” ? No. People are being humble. Just like we want successful people to be. But its not mere luck even they say they do. There is luck involved but there’s also skill. Ask someone that don’t care about good publicity like Charlie Munger and he will tell you why he’s successful in stock picking. He taught a class about it after teaching a class about psychology.

It’s not given to human beings to have such talent that they can just know everything about everything all the time. But it is given to human beings who work hard at it ‑ who look and sift the world for a mispriced bet that they can occasionally find one.

And the wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple. That is a very simple concept. And to me it’s obviously right based on experience not only from the pari-mutuel system, but everywhere else.

And yet, in investment management, practically nobody operates that way. We operate that way ‑ I’m talking about Buffett and Munger. And we’re not alone in the world. But a huge majority of people have some other crazy construct in their heads And instead of waiting for a near cinch and loading up, they apparently ascribe to the theory that if they work a little harder or hire more business school students, they’ll come to know everything about everything all the time.

Charlie Munger

Value investors beat the market because they operate on a different level than the active managers they are being compared with by the Efficient Market Theorist and Index Investors. Looking for a mispriced bet rather than buying everything on the index.

Real estate investors are a humble bunch, most of the people I know at least. When they found a good investment, they don’t say that the other person is just lucky. “Henry Sy got that prime property? That wise bastard.”. They say something like that out of respect. There’s no luck involved because they know that getting a prime property involves skill, people skills, negotiating skills, creative financing. Only stupid people attribute other people’s success as luck. Don’t be one of them.

Now its different when it comes to stocks. Because there’s this theory that has affected most people unlike in real estate where there is none. “What? Someone bought a company that grew to 10x? He’s just lucky.”. Luck may be involved in it, but concluding that the other person is just lucky immediately, takes away the skill required to spot that investment. You’re not giving him proper credit for using his brains. After all, if that business is not listed in the stock market and you’re just negotiating face to face with the business owner about the sale, do you say that the person is lucky if he closed the deal?

Another thing about the stock market is that its easy to treat it as a casino. So its easy to treat the success of people who gamble as lucky. When traders trade using charts and it went up. I contribute that to luck. But when an investor invested in a company 3 years earlier than everybody else, then it went up 10x after the 5th year, that’s not luck. That’s skill. You should know the difference.

Let’s get back to Buffett

Buffett, pressured by the peers of his value investing circle made an article that would become one of the greatest piece of article ever written on investing. It is “The Superinvestors of Graham and Doddsville”.

In it, he describes the monkeys that tosses coins. Out of the million of monkeys, through luck, there would be winners in the end that would take all the money. Its easy to attribute the success of the monkeys by luck. However, if you take a deeper look at the winning monkeys on how they are able to win at every consecutive coin toss, you might look at what they eat, at where they live, or who is the zookeeper. That might give you a clue behind that “luck”.

That metaphorical zookeeper was Graham and Dodd. If you read Buffett’s biography, everyone of Graham’s students, all the people who attended his investing class, became a great investors. They all beat the index. Some of them known, some are not known. Is this still luck? Are they exceptions, all of them? Surely. There’s no luck. Being connected to Graham intellectually disproves that luck was involved.

But we can’t be Graham students now because he’s dead. Actually, no. His teachings has been well preserved by the 2 books he left us, and by his greatest student Warren. Anyone who wanted to become a student of Graham only need to read these books and listen to Warren Buffett.

But Graham lived in a different time. What he teaches and how he invested is different. The world changed. Well, that’s true. He lived in the Great Depression. His strategy was based on that. But you’re looking at it the wrong way. That’s not what Graham was trying to tell us. The secret to investing has been out since the 1930s. The book “The Intelligent Investor” and “Security Analysis” told us the secret to beat luck. If you read that book and only got the formula out of it. You should read it again. You should learn the timeless lessons that the book teaches not the formulaic investing that Graham advocates.

Those timeless lessons were: buying cheap companies, margin of safety, Mr. Market and treating investing as a business. Those will never be obsolete.

Everyone who we consider great investors today are connected by the same set of principles. Munger is the same as Buffett even if he was not a Graham student. They are similar in ways in how to think about investment (value investing), each person only added to it from their own experience. And each person who adopts their investing concepts have the power to tilt the odds in their favor. Just like being lucky to the lay person.

There will always be luck involved in investing. Just like poker. You can either treat it as a gamble, therefore luck controlling your results. Or you can treat it like a profession where skill can tilt the odds in your favor. But don’t be naive to think that only luck is required for these great men to become great investors.

If you don’t want to play the odds, invest in an index. There’s nothing to be proud of being mediocre though. These days, people have small dreams. Then they puff their chest and tell to everyone that they made it. Do they really? Is this a millennial thing?

People have to realize that there are people who wanted challenge. Who wants to achieve great things. Who get intellectually stimulated by investing. And its not because people are deluded to think that they are geniuses. Its just human nature to strive and get better. Some want to conquer the odds. Some people don’t like mediocrity. I myself, hate it. Especially people who teach mediocrity as something good.

For me, I’d rather try hard beating the index. Than to be content at average returns. If I do beat the index, would it be luck or skill? Some people may say luck. Some people may say skill. And some people may not know enough to actually know the difference.

There was once a great saying that goes, “Any advance technology to the untrained eye looks like magic.” Well, investing is like that too. Any unskilled person who thinks that what brought a great investor success, he just regard it as luck.

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