The Motley Fool

Is Investment Performance Attributable To Skill Or Luck?

A question asked regularly is: How do we know if good performance is attributed to the skill of the investor, or if he just had a lucky break?

I have often pondered over this question because I do witness some investors taking imprudent actions which may literally destroy their portfolio, yet they may end up with good or decent outcomes due to a lucky event. An investor may be disciplined, skilful in analysis and prudent in capital deployment, yet still only manage an average return. So how much of investing success is attributable to skill, versus luck?

Defining Skill

How does one actually go about defining skill? This is the level of judgment involved in selecting securities based on their underlying fundamental characteristics, by accounting for quantitative and qualitative factors.

An investor who displays skill would have an innate sense of risk, a wide breadth of knowledge, and a good head for numbers to select good companies to invest in to compound his wealth. Aside from selecting the right companies, skill also involves portfolio sizing and the ability to replace poor performers with better-performing companies.

The Role Of Luck

Assuming one has the requisite skills and expertise to be able to select good and strong companies, and also possesses the psychological fortitude and tenacity to hold these companies through good times and bad, there is still an element of luck involved.

Bad luck may result in a good investment going sour, as even the best-laid plans may not always go as planned. As business and real-world conditions are inherently unpredictable, luck does play an important part in ensuring good performance as well.

Prudence Ensures Consistent Long-Term Results

Warren Buffett has a very famous quote:

“You only know who’s been swimming naked when the tide goes out”.

Though luck has a part to play in ensuring proper and consistent portfolio performance, prudence will ensure the portfolio will do decently and not fall prey to a major crash should a severe unexpected event occur. Though good performance is sometimes a result of good fortune, as long as an investor follows a stringent and thorough investment process, he should do well over time.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.