Understanding the Role of Chance in Investing

Successful investors are usually confident, and that can be a useful quality... up to a point. They research a potential investment, and once they have made a decision, they stick with it and don’t constantly second-guess themselves. They don’t worry unnecessarily about the normal ups and downs of the market. They aren’t afraid to go against the grain of popular opinion and buy when others are selling, or sell when others are buying.

Yet like people who have been successful in any venture, investors can be tempted to underestimate the importance of chance and luck. This, in turn, leads all too easily to overconfidence—the root cause of so many expensive mistakes in investing. Appreciating the role of chance doesn’t negate the importance of skill, and of doing your homework. But it keeps us humble, an important quality for any investor who wants to be successful over the long run. It also helps us realize how much the world of investing is governed by uncertainty and probability.

Recent research summarized in Scientific American sheds some light on the role of chance in success generally. In the paper “Talent vs. Luck: The Role of Randomness in Success and Failure,” the researchers describe advanced computer models used to explore the differences between how talent (as measured by intelligence) and success (as measured by wealth) are distributed. The distribution of talent follows a standard bell curve—with the majority of the population bunched around the middle. The distribution of wealth, on the other hand, was far more extreme—with 20% of the population holding 80% of the wealth.

Those defending the role of skill might respond with a variation of the maxim that “luck is when preparation meets opportunity.” In other words, those who succeeded were both talented and lucky: their superior skills helped them take advantage of their luck. However, the paper found that talent was a factor, but not necessarily the most important one. The most talented individuals were rarely the most successful. “In general,” Scientific American concludes, “mediocre-but-lucky people were much more successful than more-talented-but-unlucky individuals. The most successful tended to be those who were only slightly above average in talent but with a lot of luck in their lives.”

Although the “Talent vs. Luck” paper uses a theoretical model, its distributions of talent and wealth match those found in many societies. Moreover, as Scientific American notes, its conclusions are supported by previous research. Investment strategist Michael Mauboussin dives into some of this research in his book The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing.

In the book, Mauboussin presents a luck-skill continuum—with playing a slot machine at one end (pure luck) and chess (pure skill) at the other. While most activities are somewhere in between, he makes a convincing case for putting investing closer to the luck end of the spectrum. That doesn’t mean skill doesn’t matter in investing, he stresses. It just means we have to evaluate that skill differently. The closer an activity is to the pure skill end of the spectrum, the more important outcomes are. However, “where luck is rampant,” he writes, “we must think of skill in terms of a process because the results don’t provide clear feedback.”

His conclusion—that the best investors put process ahead of results, especially in the short term—is consistent with my philosophy. When you appreciate the role chance plays in investing, you realize that good decisions don’t always result in immediate gains. (Conversely, sometimes bad decisions result in good returns.) In the market, cause and effect are poorly correlated in the short run.

What happens to investors who ignore the role of chance in the market?

First, they are vulnerable to over-confidence, to overestimating their skills. If they pick a stock that goes up, they assume they have a “hot hand” and start taking unwise risks.

Second, they get caught up in the over-confidence of the market in general: what Alan Greenspan called the “irrational exuberance” of a bull market. They assume that past performance predicts future results—even though we’ve all read the fine print that says the opposite. Mutual funds that have performed well over the last year invariably attract a wave of new investors guilty of “chasing performance.” Smart investors, who realize how probabilistic the market is, understand those high performers will probably revert to the mean sooner than later.

By understanding the role that chance plays in the market, such smart investors protect themselves from being “fooled by randomness,” as Nassim Taleb puts it in his book of the same name. Going all the way back to Burton Malkiel’s classic A Random Walk Down Wall Street, the best investors have always had a healthy respect for randomness. And with that comes a healthy dose of humility that works to their advantage.