23 Oct 2019
The importance of luck (and recognising it)
Early in my career, an important mentor of mine had a favourite saying, “I’d rather be lucky than smart”. At the time, I found this strange advice, as she was clearly an experienced and highly skilled investor. I struggled to see the luck in how she generated great returns. But if I heard her say that once, I literally heard her say it a hundred times while I worked with her. In the fullness of time I have come to better understand the importance of her advice.
Primarily she was saying to avoid the arrogance that often creeps into successful professionals. The reality is that all good outcomes in life are a mix of skill and luck, but we tend to be poor at recognising it. Interestingly, as people we are exceptional at recognising where bad luck has led to bad outcomes. For example, think of all the superstitions that we have adopted to ward off the spectre of bad luck. We touch wood, we don’t break mirrors, we avoid black cats, we don’t walk under ladders, actors won’t say “Macbeth” and countless other examples. So, while we know the effect of bad luck and seek to avoid it whichever way we can; we are less good at acknowledging the role of good luck and this can all too easily lead to arrogance.
The problem with arrogance is that it is the fraternal twin of over confidence, one of James Montier’s “Seven Sins of Fund Management”. In his 2005 paper on this topic he delved into the behavioural heuristics that litter the world of investing. It’s fair to say that the seven sins combined are the reason most investors, both retail and professional, struggle to deliver returns greater than the general market. Montier believed that overconfidence by fund managers in their forecasts was a fundamental sin that led to poor performance.
He identified several problems with overconfidence in forecasting earnings. The prime reason being that virtually all forecasts are incorrect. So, overconfidence in your ability to forecast makes you poor at recognising when your forecasts are turning out wrong, which will inevitably be most of the time.
He also highlighted the problem of developing an “expert” ego. This sounds bad, and it is, but is all too easy to see why it happens. Professional investors are paid to be right, it’s their job after all. So, experts concoct elaborate and, in theory, well-backed explanations for why their views are correct. To do this requires the expert to know everything; read every paper and report ever written by and on a company, meet company management, meet customers, meet competitors, meet suppliers, meet competitors, understand the industry it operates in, develop a view on the local economy, know all about the global economy, become a currency expert, understand the relevant laws and regulations, know what the local government is going to do, know which political party or coalition is going to win the next election, know what all the central banks in the world are going to do, know what the weather is going to do and lots and lots more.
The tremendous amount of knowledge that goes into making a prediction makes it even more difficult to admit when the forecast has gone wrong. Your status as an expert can get drawn into question. Again, this makes the fund manager with an ego even slower to cut losers and buy the winners they don’t own.
The reluctance to admit mistakes leads to spending a lot of time justifying why it’s not your fault. Montier saw six key narratives that fund managers develop to explain away mistakes. “If only the Fed had cut rates” or hadn’t depending on the situation. Clearly a fund manager cannot be responsible for central banks doing the unpredictable. “Ceteris Paribus” was not observed and something unforeseeable occurred. Clearly a fund manager cannot know everything that the future holds (except their earnings forecast of course!). “I was almost right” can cover most times things went wrong and the fund manager cannot be held accountable. “I’m not right yet” can be rolled out too, even the fund manager’s broken clock is right twice a day. “The analysis was right, but the outcome was wrong” is an understandable but nonsensical excuse; why even forecast in the first place!
Arrogance tends to keep people from spending time analysing their mistakes, as Montier identifies, they spend more time trying to explain away their mistakes. This is a missed opportunity because learning to do things better is all about understanding your mistakes. Getting to the heart of mistakes, which are virtually always are a series of compounding missteps, is how we can start to make less errors of judgements. There will always be more mistakes to be made but if you can avoid making the same ones twice, progress is being made.
At Castle Point we do forecast earnings but do so safe in the knowledge they we will almost certainly be wrong. Which is why we tend to look for opportunities where a wide range of earnings outcomes over the medium term should still lead to a good share price outcome. We are well aware of what we don’t know and what we can’t control. We do know, though, that if our forecasts are completely accurate, we have, as my mentor would say, been far more lucky than smart.