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As luck would have it…

Thursday, June 16, 2016

As luck would have it…

Investors are constantly blaming their misfortunes on bad luck but does luck have anything to do with investments, on both the up and downside? Is it possible that investors, if they do get lucky, can make substantial returns on their investments and despite their best efforts, can just as easily get burned when lady luck turns her head?

Getting (un)lucky
When it comes to investing there are a number of factors that investors may be susceptible to putting down to luck. One of the most common sayings heard in the investment community is “timing is everything.” Indeed it is, but can anyone really perfectly time the stock markets? Only a rare few can time their entry into the markets right at the bottom of a bear cycle and then ride through the upside, achieving tremendous returns. However, as it is too hard to perfectly predict the timing of the troughs and peaks, investors generally believe they got lucky, or indeed unlucky if they enter at the peak of a bull cycle.

Disasters in the financial world have become more of the norm in recent times, but as ever they have become increasingly harder to predict. What if investors bought or sold the majority of stocks in a time of a disaster or when that specific stock excelled or saw a sell-off. Since timing the market with precision is virtually impossible, luck surely plays a dominant role in your fortune, or lack of it.

Additionally, investors often choose to diversify and have the majority of their investments, for the most part, in safe, defensive assets but they will also have a small number in more riskier, higher yielding assets. Diversification means that as some of these assets do well, others will struggle and minimal alpha will be generated but what if, there was an off chance that more than just a couple of those stocks headed for the moon. Is this simply down to luck?

What’s luck got to do with this?
Luck only exists in the sense that whatever random events that may occur across the world, they will inevitably impact some people, in this case investors, more positively or negatively than others. In this sense, luck can be very misleading and uninformative, but how can you ensure that you eliminate this vocabulary from your way of thinking, from an investment perspective anyways? 

Outcome based luck
Suppose you were to go to a casino and sit at a blackjack table. You put your money down and are dealt a 19. You opt for a card and everyone looks at you in disbelief, even the dealer resorts to question whether you’re sure about that decision two or three times. Well as luck would have it, you are dealt the 2, revealing that smug look insinuating that it was indeed a great decision to take the card…but was it really?

Given all things, was it really an informative decision to take a card at 19 or perhaps letting the outcome of the decision fool you into believing it was. Understanding the probabilities involved in blackjack surely tells you that you will most probably lose your money if you kept hitting on 19 because the number of cards greater than a 2 hugely outweighs those lower. As such, this is clearly an example of a bad decision leading to a good outcome through a case of blind luck. If you applied the same logic and replayed the game a number of times, you are more often than not likely to go bust. 

In these instances, bad processes will lead to good outcomes a few times because the chances are very slim but by no means impossible. But what is important to take a way is that this is all it will be – a few times – and in the end luck will play no part. Outcomes, good or bad, will all eventually be based on skill and judgement. 

It’s all skill, not luck
Every investor, whether you’re starting out or a veteran within the industry, can sharpen their investment skills. Even if past strategies have worked, the economic landscape is ever-changing so there will always be new, more innovative approaches to investing that can be learned and considered. The quality and skill set of specific risk management individuals and by association, risk systems and technology in a broader sense also plays an important part in the performance of your investments.

Relying on the professionals
What investors can do if they feel they’re out of luck is to hand over their investment work to other investment professionals and benefit from their expertise. This can be in the form of moving funds from one active manager to another, or moving to funds where certain decisions are made for you, for example any funds where the asset allocation decisions are made by industry professionals who have far better insights into investment markets (and perhaps better perceivable “luck”).  

Is luck just the right amount of patience?
The perception of luck, or lack of it, often surrounds the issue of timing in the market as mentioned previously. Yes, investors will sometimes tell you that there are observable expectations for certain stocks to reap large rewards in a short time but, more often than not, investments perform better with age, usually taking months or years before a stock achieves what you set out to achieve. 

However, assuming investors do get “lucky” and the price of a stock rises/falls substantially within a short timeframe, investors are prone to a number of outcomes which have negative implications on their portfolios. Firstly, they may sell the stock too soon in order to lock in small gains, primarily due to the behavioural trait known as loss-aversion, which comes about from the many human emotions involved in our decision-making process illustrated on figure 1. Loss-aversion involves investors strongly preferring to avoid losses rather than acquiring gains, resulting in the disposition effect where they sell winners too early and hold on to losers for too long. Investors may also move to a state of panic selling or completely abandon the stock because it didn’t perform as they had hoped or expected it to in their time expectations.

Figure 1 Market cycle of emotions

These outcomes will cause investors to lose money or lose the opportunity to increase returns, and in these cases, patience is truly a virtue and investment performance has nothing to do with luck. 

In the end, it is clear that investing has far less, if anything, to do with luck (and associated behaviours) than it does with skill, market insights and timing and the overall investment philosophy and process.

Chirag Jasani

 

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