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The Role of Luck and Randomness

Along with millions of other Americans, our office held a small pool for the NCAA basketball tournament this past March.  We filled out our brackets and let the games play out.

Well, I won, despite spending less than 7 minutes constructing my bracket (possibly to the annoyance of some at the firm). I know a little about college basketball and understand the basics but didn’t follow this past season or the NCAA tournament at all.  So how did I win? It wasn’t a superhuman ability to filter and synthesize loads of information, nor am I being overly humble or allowing my introverted nature to prevent me from taking full credit for my accomplishment.

I actually shared my secret with the team once I officially received the interoffice trophy at our staff meeting following the tournament. I’ll tell you what I told them – it was luck. My winning was a random occurrence.

Luck and randomness are ever-present in our lives, and particularly in our investments.  Here are three important things to know about luck and randomness and how we can use this knowledge to make us better investors:

  1. Don’t confuse luck with skill

Winning the office pool one time wasn’t evidence of any special skill I have for lotteries or analyzing college basketball match-ups.  Likewise, just focusing on the results of any one investment clouds the issue of luck versus skill, particularly in the short term. Maybe you did a skillful job identifying something that the rest of the market couldn’t see, but there’s a good chance that the 150% gain on that high-flying stock you bought just a short time ago was due to luck. When one can repeatedly replicate that stock picking prowess over very long time periods then maybe it ventures into the realm of skill.

  1. Don’t try to control randomness

Certain things in this world are out of our control. No matter how much fans wanted to, they couldn’t will Virginia into coming back against UMBC and not blowing up everyone’s bracket.  When it comes to investments, our firm’s philosophy is that you can’t control the markets, and we don’t try to.  Luckily, one doesn’t need to in order to be successful.  We don’t jump in and out in anticipation of what the market may or may not do.  We rebalance as necessary which creates a disciplined way to buy low and sell high, taking emotion out of the equation.  As investors, we can focus on factors that are in our control – saving, spending, and prudent diversification of our investments.

  1. Don’t try to develop patterns from random events

When we have our office pool again next year, perhaps I should use the same selection methodology that I used this year (which I don’t even remember) because maybe there’s some pattern.  It likely won’t work since there’s no pattern, even though I may think there is.  For better or worse, the human brain is hardwired to look for and create patterns, even where they don’t exist. Our brains typically look for the easiest, most efficient way to do things.  And patterns, whether true or false, allow us to do that.

When it comes to investing, there’s also no shortage of people working on patterns based on what’s happened or what might happen. It’s a little like Mad Libs for investing:  “Oil will go [down or up], which means that the dollar will go [up or down], which means that we’re ripe for a [downturn or upturn] because that’s what happened last time, which means it’s time to rotate [into or out of] this [sector/country/asset class].”

If you’re a client of the firm, you know that we believe in holding a broadly diversified set of investments for the long term.  You’ve also probably seen the investment “quilt” chart that ranks the performance of various asset classes over the last 20 years.  We love this chart because it demonstrates that trying to discern next year’s winners and losers based on the rankings of previous years is a fool’s errand. There’s no pattern, yet there’s also no shortage of ideas on how to create a pattern that’s not there.

So, it’s nice that I won the office pool and with that, bragging rights for a year, so long as I remember how it was that I won.  It was luck – pure and simple.  And I can completely accept it.

Photo Copyright: fritzundkatze / 123RF Stock Photo