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16. The most important thing is to appreciate the role of luck. From time to time, someone makes a risky bet on an improbable or uncertain outcome and ends up looking like a genius, but we must recognize that this happened because of luck and daring, not skill. The world of investing is not an orderly and logical place where the future can be predicted and specific actions produce specific results.
The truth is that much depends on luck. Some may prefer to call it chance or randomness, and these words are more sophisticated than luck, but they all boil down to the same thing. A large part of the success of everything we do as investors will be strongly influenced by the roll of the dice. Aiming to fully explore the idea of luck, I will use in this chapter some ideas presented by NC.
Nicolas Taleb in his book Fooled by Randomness. Some of the concepts explored here had already occurred to me before reading it, but Taleb's book brought them all together and added others. I consider it one of the most important books for investors. I borrowed some of Taleb's ideas for a 2002 memo entitled "And How They Get That Way in Returns and..." How do they become?
What are they? [This text] incorporates excerpts from " Fooled by Chance," represented below in italics. Chance or luck plays an important role in life's outcomes, and the consequences arising from random events should be seen as different from those that are not. Therefore, when considering whether the history of an investment might repeat itself, it's important to think about the role of chance in the manager's results.
What if good performance is the result of competence or if he was just lucky? Winning 10 million at Russian roulette doesn't have the same value as winning 10 million through diligent and skillful practice in dentistry. The value gained is the same and can buy the same goods; however, one depends much more on chance than the other.
For your accountant, however, they would be identical at heart. I cannot help but consider them qualitatively different. All histories should be considered in light of other possible outcomes. Taleb calls alternative histories those that could easily have occurred in the same way as the visible histories.
Clearly, the way I judge issues is probabilistic in nature; it is based on the notion of what could have happened. If we have heard of the great generals... The inventors of history are simply those who took considerable risks, like thousands of others, and ended up winning. They were intelligent, courageous, sometimes noble people, and had the best possible education of their time.
But the other thousands of people who live today in the shadows of history also possessed the same qualities. Occasionally, someone makes a risky bet on something improbable or uncertain and ends up looking like a genius, but we must recognize that this happened because of luck and audacity, not skill.
Think of an aggressive backgammon player who can only win if he rolls a double six on the dice, the probability of which is one in 36. The player accepts the dice, doubling the bet, then rolls them, obtaining a double six. It could have been a reckless bet, but since he emerged victorious, everyone considers the player brilliant.
We should imagine what the probability would be of him having obtained something other than a double six. Therefore, the luck the player needed to win says a lot about the probability of the player winning again. In the long run, success in investments may simply be the result of being in the right place at the right time.
I always say that... To make a profit, we need aggressiveness, time, and skill, and someone who is aggressive enough at the right time doesn't need much skill. At any given moment in the markets, the most profitable managers will likely be those who have best adapted to the most recent cycle. This doesn't usually happen with dentists or pianists due to the nature of chance.
The easiest way to see this is to note that in periods of prosperity, the highest returns often find those who take the greatest risks. This says nothing about whether these people are better investors. Warren Bilet's appendix to the fourth revised edition of Benjamin Graham's *The Intelligent Investor* describes a contest in which each of the 225 million Americans starts with one dollar and flips a coin once a day.
People who guess correctly on the first day collect one dollar from those who guessed incorrectly. A new flip is made on the second day, and so on. Ten days later, 220,000 people have guessed correctly 10 times in a row and won $ 0.00. Perhaps they try to be modest, but at parties they will occasionally admit to attractive members of the opposite sex their techniques and the wonderful insights they can offer for the study of...
Coin toss after another 10 days, we have 215 survivors who got it right 20 times in a row and won $1 million each. These people write books titled "How I Turned a Dollar into a Million in 20 Days Working 30 Seconds a Morning" and start making money giving lectures. I am a familiar face. Thus, chance destroys or contributes to the historical results of an investment to a degree that few people fully appreciate.
As a result, they underestimate the dangers that lurk behind strategies that have worked well until now. Perhaps a good way to summarize Taleb's opinions is through a table from his book. In the first column, he lists a series of aspects that can be easily confused with the aspects in the second column.
I believe this dichotomization is brilliant. We all know that when things are going well, luck and skill become confused; coincidence and causality become similar. A lucky fool ends up looking like a skilled investor. Of course, knowing that chance can generate this effect doesn't make it easy to distinguish between lucky and skilled investors, but we should keep trying.
I tend to agree with... Essentially, all the important points cited by Taleb are true: investors are right and wrong all the time for the wrong reasons. Someone buys a stock because they expect a certain event; this event doesn't occur, yet the market raises the stock price. The investor seems good and usually accepts this assessment.
We cannot evaluate whether a decision is correct based on its outcome; however, that's how people evaluate a good decision. It's the best possible decision that can be made at the point it's made, a moment when the future is, by definition, unknown. Thus, correct decisions often don't have chance, and vice versa.
Chance alone is capable of producing any short-term results in portfolios where random movements are fully allowed. Market movements can easily mask the manager's skill or lack thereof. Certainly, market movements cannot be credited to managers unless we see the rare case of people capable of repeatedly predicting these movements.
For these reasons, investors often receive credit for something they don't deserve. A good stroke of luck can be enough to build an entire reputation, but this clearly depends entirely on chance. Few of these "Enios" have been right more than once or twice in a row, so it's essential. Having a large sample of cases, many years of data, before analyzing the ability of a particular manager, Taleb's idea of alternative histories—the other things that could reasonably have happened—is a fascinating concept and particularly relevant to investments.
Most people recognize the uncertainty surrounding the future but feel that at least the past is a known and permanent fact. After all, the past is absolute and immutable history. Taleb, however, suggests that the things that happened are only a small subset of the things that could have happened. Thus, the fact that a strategy or action worked under the circumstances that unfolded does not necessarily prove that the decision that motivated it was sensible.
It is possible that the success of that decision is linked to a completely improbable event that at that moment depended only on luck. In that case, the decision, however successful it may have been, may have been imprudent, and the many other stories that could have happened would have demonstrated the error.
How much credit should a decision-maker receive for betting on a highly uncertain outcome that luckily had a happy ending? This is a good question and deserves to be analyzed in greater depth. One of the first things I remember learning when I joined Von in The 1963 discovery that the quality of a decision is not determined by its outcome; rather, events that may occur after decisions are made make them good or better.
However, these events are often far beyond any prediction. This was strongly reinforced by Taleb's book, which highlights the capacity of chance to reward imprudent decisions and penalize good ones. What is a good decision? Let's say someone decides to build a resort in Miami. Three months later, a strange blizzard hits South Florida, leaving 4 meters of snow in its first season.
The area receives robust profits. Does this mean that the idea of building the resort was good? No, a good decision is one that a logical, intelligent, and well-informed person would have made under the circumstances as they presented themselves at that moment, before the outcome became known. By that standard, the resort says that in Miami seems crazy.
Just as with the risk of losing money, many things that cannot be known or quantified in advance will affect the perception of the quality of the decision made, even after the event has occurred. It is difficult to know for sure who made a good decision based on a solid analysis but was penalized by an anomalous situation, and who...
Those who benefited from relying on luck in highly speculative investments may not know who made the best decision. On the other hand, past returns can be easily evaluated by shedding light on who made the most profitable decision. Although it's easy to confuse decisions, alert investors need to be very aware of their long-term differences.
There is no reasonable alternative but to believe that good decisions lead to short-term profits. However, we must remain passive when they don't bring us profits, since investors of the "dua school" (I know, described in Chapter 14) believe it's possible to know the future, they also decide what it will be like, build portfolios designed to maximize returns based on that scenario, and largely disregard other possibilities.
Sub-optimizers of the "dua school" (I don't know), on the other hand, place their emphasis on building portfolios that will perform well in scenarios they consider probable and not too badly in the rest. Investors of the " dua school" predict the outcome of a dice roll, attribute their successes to their astute intuition about the future, and when things don't go their way, they blame others.
The question we should ask when they are right is whether they truly glimpsed the future or not, given their probabilistic approach. Investors of the Dua school (I don't know which) understand that the outcome largely depends on the gods, therefore the credit or blame of investors, especially in the short term, should be adequately limited.
The Dua school (I know which) quickly and confidently divides its members into winners and losers based on the first or second roll of the dice. Investors of the Dua school (I don't know which) understand that their skill should only be judged after the dice have been rolled many times, not after just one roll, and that the rolls may be few and far between.
Thus, they accept that their cautious and suboptimal approach may, for a time, produce indistinct results. However, they trust that only the long term will tell if they are excellent investors. Short-term gains and losses are potential imposters, as neither necessarily indicates the investor's real competence or incompetence.
Surprisingly good returns are often just the other side of the coin of surprisingly bad returns. A year of good returns can inflate a manager's competence and obscure the risk they took. Yet, people are surprised when this year of good results is followed by a terrible year. Investors often forget that both short-term gains and losses can be imposters and that it's important to work hard to understand what's behind them.
Investment performance is what happens to a portfolio as events unfold. People pay close attention to the performance outcome, but they should question two things: were the events that actually happened and the other possibilities that didn't occur truly part of the portfolio manager's knowledge? The second is what the performance would have been if other events had occurred, and these other events are the alternative stories to Taleb's.
I consider Taleb's ideas new and provocative at the moment when we understand how much chance can affect investment results. Everything starts to be seen in a very different way. The actions of the Dua school, I would say, are based on a single possible future which can be known and achieved. The people of my Dua school, I don't know how to see future events in terms of a probability distribution.
This is a big difference in this. In the last case, we can get an idea of the most likely outcome. But we also know that there are many other possibilities and that these other outcomes may have a much higher collective probability than what we consider most likely. Clearly, Taleb's view of an uncertain world is much more similar to my way of seeing it.
Everything I believe and recommend about investing comes from this school of thought. We should spend our time trying to find value in what is possible to know: sectors, companies, and assets, instead of basing our decisions on expectations regarding the least known, such as the global macroeconomic scenario and the performance of the broad market.
Given that we don't know exactly what the future will be, we must keep value on our side by having a strong, well-analyzed opinion about it, buying for less when opportunities arise. We need to invest defensively since we will probably be going against the grain of many outcomes. It is more important to ensure survival during periods of negative results than to guarantee maximum returns in favorable periods.
To improve our chances of success, we must emphasize the opposite view to that of the herd. In periods when the market is at its extremes, being aggressive when the market is down and cautious when it is up, given the nature of the market. Given the highly indeterminate nature of the results, we must view strategies and their good and bad outcomes with suspicion until they prove to be good or bad after a large number of tests.
Many aspects go hand in hand for people who see the world as an uncertain place: a healthy respect for risk, an awareness that we don't know what the future holds, an understanding that the best we can do is view the hole as a probability distribution, invest accordingly, insist on defensive investing, and emphasize avoiding pitfalls. For me, that's what sensible investing is all about.
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