Is luck part of your investment strategy? If you are an investor attempting to beat the market, luck influences your results more than you probably realize.
Michael Mauboussin, author of the book, The Success Equation, Untangling Skill and Luck in Business, Sports, and Investing, writes that in activities which involve both skill and luck, as skill increases so does the role luck plays in the outcome. He calls this counterintuitive phenomenon the paradox of skill.
To explain, Mauboussin begins with a simple observation; between 1932 and 2012, more than 23 minutes were shaved off the winning time for the Olympic marathon. What’s more, the time gap between 1st and 20th place shrunk from 39 to 7.5 minutes. An expanding talent pool and enhanced training techniques caused absolute results (winning times) to improve and relative results (gaps between best and worst finishers) to narrow. In other words, the best marathoner today is better than ever, but only a little faster than the competition.
Investors have also become more skillful as a collective group over time. Information from companies, analysts, government agencies, and the media has never been so abundant. Advances in technology and computing power make it easy not only to access this information, but also to “crunch” the numbers. The potential rewards of market-beating investment results are so high that many of the best and brightest students are attracted to the investment business. With so many capable, well-informed, and highly-incented investors trading each day, market prices quickly reflect all known information.
Ironically, better information, computers, and talent, doesn’t set an investment firm apart or increase their chances to produce market-beating returns. Today, most firms have access to such things. Since market prices reflect all known information and new information which might move markets can’t be accurately predicted, luck has become more important than it used to be in distinguishing “winners” from “losers.”
When attempts to beat the market fail—as numerous studies show occurs about 80 percent of the time—investors miss returns which could have improved their standard of living in retirement, helped kids and grandkids, or benefited their favorite charity.
If you don’t feel comfortable with the fate of your nest egg riding on good fortune, you’re in luck: By understanding the odds of beating the market are too remote, and instead, building an evidenced-based portfolio using low-cost index funds, you can take a needless element of chance out of the equation.