Don't Turn Luck Into Disaster

"I'd rather be lucky than good."

Former Yankees pitcher Lefty Gomez is said to have been the first to utter this familiar line, after his outfielders ran down three hard-hit balls in one inning. And we can all empathize -- sometimes a lucky break seems to net us more good fortune than all of our hard work.

But I'm here to tell you that, as an investor, being good is much better than being lucky over the long run. It was the same for Gomez; he didn't get into the Hall of Fame on luck. He won 20 or more games four times for the Yanks in the years leading up to WWII and helped his team win seven pennants.

In fact, I'm here to tell you that getting lucky a few times as an investor can be downright dangerous.

Anchor away!
Let's say you've been watching the movement of several stocks. Up, down, up, down. "Just like a bouncing ball," you think. "I know I can time these movements and make a few bucks buying and selling." And so you try it, and it works. For a couple of weeks, you buy Pfizer and Pepsi and Amazon.com and anything else on a downturn, and then you sell them the same day for a small profit.

Soon, though, you run into a few losses because the bouncing ball doesn't bounce back up all the time. Despite a good profit in the first couple of weeks, you wind up breaking even for the month. The next few months, you lose money.

Despite a lack of success, you continue trying this "system" on and off for a few years. Why? Because -- through randomness and luck -- it worked really well the first few times. Our brain remembers this and doesn't easily forget the information. In fact, the process is called "anchoring." David Gardner wrote about it a few years ago in a special series called The Psychology of Investing.

Quoting from the book Inevitable Illusions: How Mistakes of Reason Rule Our Minds by Massimo Piattelli-Palmarini, our brain "remains anchored to the first product we obtain. We seem never to stray far from that -- or never far enough. It is as though we were unable to forget our first estimate." Piattelli-Palmarini is referring to an experiment explained in part two of David's special, but it's easy to apply the example to our Internet day trader.

Danger lies here
Similarly, as David pointed out, those who got their start right before the Great Depression likely had a tough time moving money into stocks again. "My grandparents were anchored in the belief," he wrote, "that the market was risky and might crash again at any time."

When I wrote a similar article in September of 2003, I noted that we'd all just lived through a little crash of our own and a two-year bear market that shaved off about half the market's value. I wrote that I hoped new investors wouldn't stay out of stocks for years because of that experience, because I believe it's a huge mistake for anyone with a long-term outlook not to be in the market and not to stay in the market. Now, two-and-a-half years later, investors in an S&P 500 index fund are up over 25%. Admittedly, a "lucky" short-term call for me.

Mutual fund madness
There's another way randomness and luck can cost you money: by chasing the hottest mutual funds or stocks, solely on recent performance. If you take the average returns of all equity mutual funds in any one year, for example, there will be several that outperform that average by a significant amount through randomness and luck.

Burton Malkiel has some good examples in his book, A Random Walk Down Wall Street. During the late 1980s and 1990s, he found that a mutual fund manager who was better than average in one year had less than a 50% chance of beating the average the next year. He also followed the top 10 funds of 1968 -- which was close to the top of a bull market -- for six years. The results were "perfectly disastrous," with four of the funds going out of business by 1974 and the rest worth a fraction of their 1968 value.

Though not as drastic, the trends continued through the decades. The top five funds in the '70s -- Twentieth Century Growth, Templeton Growth, Quasar Associates, 44 Wall Street, and Pioneer II -- finished, respectively, in places 176, 126, 186, 309, and 136 in the '80s.

But wait, there's more. Compare results for the five best-performing funds from 1978 to 1987 to the ensuing 10 years:

Source: A Random Walk Down Wall Street

To be fair, there are always some consistent performers. And though it's hard to identify them ahead of time, I've come to believe it can be done -- and is being done by Shannon Zimmerman in Motley Fool Champion Funds. He says that in order to beat the S&P, a fund needs a talented manager with a long-haul track record of success, a cheap price tag, and a sound stock-picking strategy -- among other traits.

It's easier to lay out the criteria than actually find the right funds, but Shannon is doing it: His recommendations are beating the S&P and relevant benchmarks by an average of 20% to 10%. (You can see all his picks with a 30-day free trial.)

Lefty's legacy
Do keep randomness, luck, and "anchoring" in your thoughts. Don't interpret early investing results as gospel. Don't chase hot mutual funds or stocks. Finally, do keep a certain humility about you, especially when things are going well. There was no finer example of this last tenet than Lefty Gomez himself. I'll leave you with a couple more of his sayings:

"I want to thank all my teammates who scored so many runs and Joe DiMaggio, who ran down so many of my mistakes."

"A lot of things run through your head when you're going in to relieve in a tight spot. One of them is, 'Should I spike myself?'"

For more information on a 30-day free trial to Champion Funds,click here.

This article was originally published on Sept. 24, 2003. It has been updated.

In the spirit of humility, Rex "Righty" Moore would like to thank all the little people. He owns no companies mentioned in this article. Pfizer and Microsoft are Motley Fool Inside Value recommendations. eBay and Amazon.com are Motley Fool Stock Advisor recommendations. The Fool has adisclosure policy.