Luck has a huge impact on trading and investment results, but it’s a topic that isn’t discussed much. Investors like to believe that they can control the results of their trades, so they assume that there is a direct correlation between forecasting skill and investment performance. Great performance in investing and trading has much more to do with strategy and discipline than forecasting, but many people cling to the illusion that being able to predict the future is the key to success.
In other forms of speculation, such as poker or sports gambling, the role of luck is very obvious. We are at the mercy of future events, and no one seriously believes that they can accurately predict the next card that might be turned over. The stock market has very different dynamics, and many people are absolutely convinced that they can predict the future, even when there is no evidence that anyone has ever been able to do so consistently in the past.
In his “Fooled by Randomness. In The Hidden Role of Chance in Life and Markets, Nassim Nicholas Taleb discusses how people underestimate chance and overestimate causality. There is a tendency to think that the performance of the market is due to some obvious factor, when the reality is that the market just moves randomly. It is very easy to make this market mistake when someone creates a story and then mines data to prove that the reason the market moved was because of what they saw and not because of other reasons.
Taleb also discusses how there is a tendency to believe that the world is more explainable than it actually is. People tend to look for explanations when there really isn’t one. We see this all the time in the market when the financial media tries to find reasons to explain the price action that just happened. There is always some event that correlates with price action, but whether or not it is truly a causal factor is not so clear.
Another book that addresses the luck vs. skill issue is Thinking in Betting. “Making Smarter Decisions When You Don’t Have All the Facts” former professional poker player Annie Duke observes that we shouldn’t assume that good results mean we’ve made good decisions, and that bad results don’t necessarily mean we’ve made bad choices. The quality of our decision-making is not necessarily reflected in our results.
This is an extremely important point. In poker, we can execute a perfect strategy and still lose because of the fall of the cards. You can also play the hand like a complete idiot and still win if Lady Luck is on your side. The same is true in trading and investing, we can have perfect logic, great insight and a clear understanding of all the facts, but that is no guarantee that we will have positive results. Luck will play a large role in determining the outcome.
The only way to improve as a poker player or as a trader is to separate the luck component and focus on the elements of your thinking that have the most real impact on your results. If we focus solely on results and don’t dig in and find out what role luck played in trading, we won’t really understand the quality of our thinking.
Many market players are currently celebrating their bullish forecasts. They probably made a very good argument for their point and had some great insights. However, it is highly unlikely that they would have predicted that the market would be as positive as it has been, or that a small group of stocks would have a historic level of performance. There’s an element of luck there, too, but we like to believe that we predicted all of this.
How do we view the role of luck in trading and investing?
1. Don’t underestimate the prevalence of luck. Whenever you enter a trade or investment, it’s important to consider what can go right and what can go wrong, but it’s also important to understand that something completely unexpected can happen. There is always risk there and there is no way to eliminate it. It will hit you regularly.
2. Make sure you have strategies to overcome bad luck. One of the main reasons it’s important to use different forms of diversification is to make sure bad luck doesn’t wipe you out. Your own protection against an ugly surprise is to not take too many positions that are inconsistent with the rest of your portfolio. It also means you won’t have as much leverage when luck hits, so it’s a constant battle to find the right balance.
Money management is essentially luck management. The idea is to find a methodology that limits the damage of bad luck while enabling the benefit of luck. It requires constant vigilance, hard work and good strategy and tactics.
3. Focus on the elements of trading that have the most real impact on results. In most cases, it will be money management, not a big, bold prediction about the future. The only way you can improve as a trader is to isolate the luck component of trading and focus on the elements of your thinking that will have the most real impact on results, such as timing, stop levels, news events, etc. If you focus solely on results and don’t dig in and find out what role luck played in each trade, you won’t understand the quality of your trading process.
When you hear stories about good or bad trading, assess how much of the outcome is due to skill or insight, and how much is just a lucky confluence of events. The more you understand how luck affects the situation, the easier it will be to find ways to improve your results.
Luck, both good and bad, is your constant companion in trading. The more you appreciate and understand it, the better your chances of making high returns.
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