Quick question, what do investment managers do?
If you say to make a lot of money for their clients, you are right.
But what if you were an investment manager who was asked to create a terrible investment portfolio on purpose? In other words to lose money as much as possible.
How would you start building such a disaster?
You could ignore basic rules of good investing by choosing only a few stocks without diversifying your portfolio. Another way to make things worse would be to buy overpriced stocks, which research shows tend to perform poorly over time.
By doing these things, you’d be going against the common wisdom of successful investing.
Surprisingly, even with all these poor choices, there’s a chance your terrible portfolio might actually do well! True, having only a few stocks raises the risk of poor performance, but it also means you could beat market benchmarks.
While buying overpriced stocks is generally a bad idea in the long run, it might show optimism for the future in the short term. So, even if you put together a messy and seemingly doomed portfolio, it might still perform better than you’d expect.
Now, imagine you’re trying to lose a game of chess on purpose. It’s not that hard, right? For many of us, losing at chess is easier than winning.
When trying to figure out if a task is mostly based on luck or skill. In games of skill, it’s tough to lose on purpose, but games of luck, like roulette, are easier to lose despite trying to win.
This leads us to wonder: Is investing more about luck or skill, and how does that affect the way we make investment decisions?
Luck plays a significant role in investing, as there are many factors beyond an investor’s control that can impact the performance of their investments. Market fluctuations, for example, can cause stock prices to rise or fall unexpectedly, sometimes leading to large gains or losses in a short period.
Economic conditions, such as recessions or periods of rapid growth, can also have a major influence on investment outcomes, as they affect the overall health of businesses and industries. Additionally, political events like elections or policy changes can create uncertainty in the market, making it difficult for investors to predict how their investments will perform.
Cognitive biases can further complicate the role of luck in investing. One such bias is the illusion of control, where investors may overestimate their ability to predict or influence market outcomes. This can lead to a false sense of confidence in their investment decisions, despite the numerous external factors that are beyond their control.
Another related bias is hindsight bias, where investors may look back at past events and believe they could have predicted the outcome, even when it was largely influenced by luck. This bias can cause investors to attribute their past successes to skill and underestimate the role of luck, which may lead to overconfidence in their future investment decisions.
I have a story about two friends who took very different approaches to investing in the stock market, highlighting the role of luck in their investment outcomes. Let’s call the first one Jack and the second one Bob.
Jack had no knowledge of investing and simply decided to buy stock in a big bank that he liked, without considering any fundamental factors or conducting any research. He just bought the shares and hoped for the best. As simple as that.
On the other hand, Bob had a comprehensive understanding of stock investing and was even able to write detailed analyses. He carefully chose to invest in a glass company, anticipating a surge in demand for glass products.
However, the outcome of their investments was quite surprising and demonstrated the role of luck in the stock market. Over the course of three years, jack who invested in the bank stock saw a return of more than 50%, despite his lack of knowledge and research. It seemed that luck was on his side, as the bank performed well and its stock price increased.
Meanwhile, Bob who invested in the glass company experienced a significant loss, even though he had carefully analyzed the investment. The glass company’s stock plummeted due to its debt in foreign currency. As the value of the foreign currency increased due to rising interest rate, the company’s debt burden grew, resulting in a decrease in its profits and, ultimately, a sharp decline in its stock price.
In this case, bad luck and unforeseen circumstances played a role in the poor performance of the investment.
This story demonstrates that despite careful analysis and knowledge, the unpredictable nature of the market and the role of luck can still lead to unexpected results. It serves as a reminder that even the most informed investors can’t always predict the future and that sometimes, fortune favors the bold — or simply the lucky.
