A few years ago, I heard the story of a money manager who, at his fund's annual meeting, renounced one of his best investments.
The stock had risen dramatically, and as a result, his investors were pleased. The problem, he said, was that his analysis was all wrong. He had thought the stock would double on the back of three particular strategies. He ignored a fourth, believing it would be negligible. Of course it was the fourth that went gangbusters and propelled the business and the stock straight up.
I've never heard a story like that before or since
This story stuck with me because it was so unusual. Our human tendency is to believe any good outcome is because of our skill, and any bad outcome because of bad luck. As a result, we neither account for luck nor analyze the results to improve our skills -- both of which can undermine our investing.
In The Success Equation, Michael Mouboussin, chief investment strategist at Legg Mason Capital Management and an adjunct professor of finance at Columbia Business School, makes a strong argument that the failure to distinguish between luck and skill -- and create strategies that account for both -- leads to poor decision-making.
Investing is a complicated blend of luck and skill, and no one will earn a perfect score. Over time, though, even small initial differences in returns can have a large effect on your portfolio. Here are three lessons from Mouboussin that can improve your decision-making -- and your portfolio.
Focus on the long term
When luck plays a large role in a given activity, it takes many iterations of the activity for skill to show itself in the results.
Take poker, for example. The distribution of the cards is random, and you can't predict who will win each hand. Over many hands, however, you'd expect the better players to win more often. Chess, on the other, involves no luck at all. It's reasonable to predict that the better player will win each game.
The movements of stock prices on any given day are driven by millions of individual decisions to buy and sell. Despite headlines purporting to tell us why the market moved up or down, there's no way to tell why each investor decided to buy or sell that particular security at that particular moment. Cause and effect are beyond murky.
Over the course of a year, however, both the individual decisions and the market fluctuations smooth out, and it's easier to point to broader causes. While randomness never quite exits the scene, the longer you're in, the more your skill has time to show.
As Benjamin Graham said, "In the short run, the market is a voting machine but in the long run it is a weighing machine."
Develop (and use!) a strong process
Our brains are economical, and we like to spend the least amount of brain power possible for any given decision. This works well in situations that are predictable and stable, but not so well in situations that are complicated and hard to predict. While relying on guts, rules of thumb, and quick analyses can get you some wins in the market (remember luck!), they aren't likely to give you a winning record over time.
Creating a robust process you follow each time you invest or evaluate an investment will improve your skills by forcing you to slow down and think through your decision.
In addition, regularly analyzing your results -- writing down what you thought would happen and comparing it to what actually happened -- will improve your process. Over time, the feedback loop of improved process and improved skills will result in a better overall portfolio.
Account for luck
We're narrative creatures; there's evidence that one whole hemisphere of our brains spends its time stitching together the story of our experience. Narrative, however, presumes cause and effect, when in fact there were multiple possible outcomes.
Take my dogs. Every day, the mail carrier walks up to the mailbox attached to the railing of my porch and delivers the mail. Every day, my dogs bark their fool heads off until the mail carrier moves along to the next house.
You know, and I know, that the mail carrier moves along to the next house because that's what happens in delivering the mail. My dogs, on the other hand, seem to believe that it's their barking that convinces the mail carrier to "back off the territory, man." And so, no matter how many times it happens, they bark. Because they think it works.
You do the same thing when you attribute wins to skill alone and losses to bad luck. Recognizing the ways luck has affected your outcomes will help you zero in on which assumptions accurately predict gains and which only seem to predict gains.
Recognizing the effects of luck can also help you develop strategies for building a portfolio that's diversified enough to not get taken down with one bad call, but concentrated enough that wins can make a real difference.
The Foolish bottom line
Mouboussin's book isn't perfect, of course. He has a tendency to repeat himself, and he'd like us average people to spend more time on actual statistical analysis that seems likely or reasonable.
But his larger point -- about accounting for luck in our decision-making -- is a crucial one for any investor who wants to beat the market over time.