Jeremy Chia reminds us that investing is a game of probabilities. In any game where probability is a factor, luck undoubtedly plays a role. This leads to the age-old question of how much of our investment performance is impacted by luck?
Is an investor who has outperformed the market a good investor? Similarly, is an investor who has underperformed the market a lousy investor? The answer is surprisingly complex.
Long term stock prices tend to gravitate toward the present value of the company’s expected future cash flow. However, that future cash flow is influenced by so many factors that result in a range of different possible cash flow possibilities. Not to mention that on rare occasions, the market may grossly misprice certain securities. As such, luck invariably plays a role.
Skill is one aspect of investing that is hard to quantify. However, there are a few things Chia looks at. First, we need to analyse a sufficiently long track record. If an investor can outperform his peers for decades rather than just a few years, then the odds of skill playing a factor become significantly higher. Although Warren Buffett may have been lucky in certain investments, no one can deny that his long-term track record is due to being a skilful investor.
Next, focus on the process. Analysing an investment manager’s process is a better way to judge the strategy. One way to see if the manager’s investing insights were correct is to compare his original investment thesis with the eventual outcome of the company. If they matched up, then, the manager may be highly skilled in predicting possibilities and outcomes.
Third, find a larger data set. If your investment strategy is based largely on investing in just a few names, it is difficult to distinguish luck and skill simply because you have only invested in such a few stocks. The sample is too small. But if you build a diversified portfolio and were right on a wide range of different investments, then skill was more likely involved.
Mauboussin wrote: “One of the main reasons we are poor at untangling skill and luck is that we have a natural tendency to assume that success and failure are caused by skill on the one hand and a lack of skill on the other. But in activities where luck plays a role, such thinking is deeply misguided and leads to faulty conclusions.”
Chia concludes that it is important that we understand some of these psychological biases and gravitate toward concrete processes that help us differentiate between luck and skill. That’s the key to understanding our own skills and limitations and forming the right conclusions about our investing ability.