Watching the Olympics a few weeks ago, I got pulled in to the drama of short-track skating. It has to be one of the more entertaining Olympic events. The races are fast, and almost anything can happen. If you had a chance to watch the women’s 500-meter final, you saw a perfect example of the fine line between skill and luck that drives this sport.
Seconds after the race started, Elise Christie of Britain made a passing move in the second turn that caused her and Arianna Fontana of Italy to crash. Park Seung-hi of South Korea then slipped in the next turn. Only one skater, Li Jianrou of China, didn’t fall down. While the other skaters managed to get back up, there was no way for them to catch Ms. Li, and she won the gold medal.
Ms. Li is clearly an exceptional athlete (she was overall world champion in 2012), but it’s impossible not to see the role that simple luck played in the race. Even she described her win as “very lucky.” Skill may have gotten her to the Olympics, but luck played a role in her gold-medal victory.
So if Ms. Li, a world-class athlete, is willing to acknowledge the role of luck in her success, what makes it so hard for the rest of us? Well, we like thinking we’re just that good, particularly if we’re talking about our investment success. As a result, we become the lucky fools that Nassim N. Taleb described in his book “Fooled by Randomness.”
“Lucky fools do not bear the slightest suspicion that they may be lucky fools — by definition, they do not know that they belong to such category. They will act as if they deserved the money. Their strings of successes will inject them with so much serotonin (or some similar substance) that they will even fool themselves about their ability to outperform markets (our hormonal system does not know whether our successes depend on randomness),” Mr. Taleb wrote.
What sets off the lucky fool syndrome? Psychologists call it the self-attribution bias. It means we’re inclined to take all the credit for things going well, but we have no problem blaming outside forces when things go wrong. On top of our bias, we have a very difficult time separating skill from luck.
As a result, we’re susceptible to the lucky fool syndrome and the problems that come with it. In a 2013 study, the researchers Arvid Hoffmann and Thomas Post highlighted how a self-attribution bias can hurt investors and lead to repeated mistakes because they “simply attribute bad returns to factors beyond their control.” The same study also showed that when we ignore the role of luck, we’re also blind to bad investment behavior like overtrading or underdiversification.
Knowing that these issues exist, we have a choice. We can continue to float along on a cloud of serotonin, playing the fool and suffering the consequences, or we can challenge our biases. It’s not easy to make the right choice, but it’s doable. It starts with getting a better handle on the difference between skill and luck.
Michael Mauboussin, the managing director and head of global financial strategies at Credit Suisse, suggests clearing up the confusion with a simple question:
“There is actually a very interesting test to determine if there is any skill in an activity, and that is to ask if you can lose on purpose. If you can lose on purpose, then there is some sort of skill. Investing is very interesting because it is difficult to build a portfolio that does a lot better than the benchmark. But it is also actually very hard, given the parameters, to build a portfolio that does a lot worse than the benchmark. What that tells you is that investing is pretty far over to the luck side of the continuum.”
So if investing involves a fair bit of luck, then the next step is to measure where our success falls on the luck-skill continuum. Plus, the more we measure, the more likely we are to avoid the bias and act the lucky fool. After all, investing leaves a pretty clear trail of breadcrumbs.
Start by pulling out tax records and year-end brokerage statements that lay out the facts. If we’ve been cruising along and assuming we’ve done something special, it’s time to put on our no shame/no blame hat and look at all the data. For instance, many investors I know designate a small portion of their portfolio as a play account. Because it’s a play account, they feel comfortable betting on riskier investments, and sometimes those riskier investments deliver an excellent return.
But it doesn’t take much for us to project that small success across our entire portfolio. So we need to ask ourselves how our whole portfolio did. Then, we need to calculate our rate of return and compare it with the return of index funds representing the broad market.
My experience shows this test will surprise almost every investor. The numbers will invariably make the case that what we thought was a spectacular success can’t compete when it’s measured as a part of the whole and compared with a benchmark. With this knowledge, it becomes a bit easier to counter our bias and avoid the lucky fool syndrome.
It’s easy to get sucked into believing that investing success is all about skill. I suspect it follows the rule that the smarter you are, the smarter you think you are, and that’s a problem for investors who believe intelligence determines our investment returns. It becomes a self-confirming cycle if they see great investments returns. The great returns verify the original idea that our smarts determine our investing success, and the next investing success starts the cycle all over again.
We can interrupt the pattern, and avoid the mistakes that come from it, by testing the context of our success with a second, simple question: Were the markets already going up? Even though it’s tempting, we shouldn’t confuse being a genius with a rising market. For instance, if we experienced superior returns in 2013, it’s very difficult to attribute our success to skill. However, we’re inclined to be very selective when we look at our success. We highlight the events that confirm our bias and ignore the facts that point to outside forces.
In this case, we’ve got the data to test our theory. How did we do in a non-record-breaking year? Did we see incredible results or were they close to the benchmark? If it’s the latter, it’s hard to argue that our smarts have built a portfolio that does a lot better than the benchmark.
Look, I understand that we really like how the lucky fool syndrome makes us feel. Besides all that lovely serotonin flooding our system, we love the idea that we’re really that good and capable of beating the market. That said, I doubt any of us wants the consequences of being the lucky fool. So it comes back to the choice I raised earlier: Do we float along or do we challenge the bias?
This commentary appeared March 10 on NYTimes.com.
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