The question of luck versus skill is one that comes up quite regularly in investing. It is not unusual for some investors to claim that the stock picks that have done well in their portfolios are down to skilful share selection. They will crow about their success to anyone and everyone. And, yet, in the same breath, they will assert that the ones that have not done so well – or have crashed – are the result of bad luck. If you think about it logically, both statements cannot possibly be true at the same time. It is not possible…
The question of luck versus skill is one that comes up quite regularly in investing. It is not unusual for some investors to claim that the stock picks that have done well in their portfolios are down to skilful share selection.
They will crow about their success to anyone and everyone. And, yet, in the same breath, they will assert that the ones that have not done so well – or have crashed – are the result of bad luck.
If you think about it logically, both statements cannot possibly be true at the same time.
It is not possible to attribute shares that have done well to your skill as an investor but blame the ones that have not performed well to bad luck. So, which is it to be?
Peace of mind
Do we need to be truly skilful or do we need to be very lucky to succeed in investing? And how can we tell, if only for the sake of our own peace of mind and our egos, if our success has been due to luck or skill?
One good way to decide is to be totally honest with ourselves and determine if our stock selections are based on a strategy. Not just any old strategy, I should add.
Instead it should be a coherent and logical strategy that can be shared openly and explained with confidence to other investors. If the strategy involves a list of stocks, a blindfold and a set of darts, then I think we can safely say that skill has had very little to do with selecting the stocks.
But if you are able to communicate and articulate an intelligible strategy and replicate the approach time and again, then it is very likely that skill has played an important part in your choosing your stocks.
Skilful investors should also be able to explain in detail – and without embarrassment – why each stock deserves to be kept in their portfolios.
Time is another good tell-tale sign of a skilful investor. There is little doubt that luck can sometimes play a big part in the short term. That could be for anything up to five to seven years, which is also roughly the time that it can take for a market to go through its typical economic cycle.
Right place, right time
So a lucky investor could perform well simply because the economy is performing well too. And in so doing, the investor might believe that the success is due to skill, when in fact it is merely because he or she was in the right place at the right time.
But beyond that timescale, luck for the lucky investor could quickly run out. In fact, the longer that you can outperform the market, the more likely you can attribute your success to skill. No one can possibly deny that Warren Buffett’s decades of success can be attributed to anything other than skilful investing.
A skilful investor should also be consistently successful. Peter Lynch, who is another very successful investor of our time once said: “In this business, if you’re good, you’re right six times out of ten. You’re never going to be right nine times out of ten.”
So, if at least six out of every ten shares that you have picked have done well, then it is quite likely that skill has played an important part in your stock selections. But if your success is due to one solitary big winner, then luck might have played a big part in your outperformance.
There is nothing wrong with that. But just thank you lucky stars and walk away. In fact, think seriously about putting your proceeds into an index tracker, such as the STI ETF (SGX: ES3), which could deliver a return of around 8% a year. Why? That is because it might not be that easy to repeat the same trick again, if ever.
Finally, how we handle failure can provide some big clues as to whether our success is down to skill rather than luck.
Successful investors will always be able to accept failure in their stride because they know that to come out ahead you don’t have to be right all of the time. Skilful investors know that they will inevitably make mistakes along the way.
But they will never blame anything or anyone other than themselves for shares that underperform. Instead, they will go back and find out why and where they might have gone wrong.
They will always start with a thesis, build a model around the thesis and decide if an investment makes good sense, whilst leaving a good margin of safety. That is the mark of really skilful investors.
They work hard at their strategies because as American movie producer, Samuel Goldwyn, once said: “The harder I work, the luckier I get”.
A version of this article first appeared in the Straits Times.
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