The role of luck in investing.

How to understand Wall Street.
Sept. 13 2004 2:58 PM

Smart? Skillful? Probably Just Lucky

The (vast and unappreciated) role of luck in investing.

Read Henry Blodget's detailed disclosure statement here. To read previous installments in the Complete Guide to Wall Street Self-Defense, click here.

It's that time of year again. Wall Street strategists are updating predictions for the current year and offering them for the next. They are analyzing interest rates, valuations, profits, economic policies, geopolitics, sentiment, technical and quantitative metrics, and/or dozens of other factors—most of which, as we've discussed, are less helpful in predicting one-year market performance than they are commonly thought to be. And, as usual, most strategists are predicting that the market is going to go … up.

Which is understandable. Because the market usually does go up. If not for the exact reasons that the strategists predict, well, then, just because it usually goes up. From 1872 to 2003, according to data compiled by Yale's Robert Shiller, the S&P 500 rose in 83 of 132 years (63 percent) and fell in 49 (37 percent). Strategists who predicted the market would rise every year, in other words—regardless of the logic used—would have been right nearly two-thirds of the time. In the investing business, you can make a lot of money and acquire a solid reputation if you are right two-thirds of the time.

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But this is why market forecasting is different from, say, astrology or tarot-card reading: In the markets, the future is not unlimited—it is binary. Stocks and markets can only go up or down. And this, in turn, is why thousands of professionals and millions of amateurs who are perceived as having forecasting skill may, in fact, have no more ability than a Halloween-party swami with a gag-store turban and crystal ball.

Because stocks and markets can only go up or down, analysts, strategists, and investors often have at least 50-50 odds of being "right." (The odds that any specific stock will rise are likely worse than those for the S&P 500, but on average, they are probably still close to 50-50.) Fifty-fifty odds are pretty good odds—better than any you'll find in Las Vegas, for example (and it is worth noting that ubiquitous awareness of this doesn't stop millions from jetting to the desert and gleefully throwing money away). Because the stock market is not random, moreover, but loosely tracks the growth of profits and dividends, forecasters who predict the market is going to rise have better than 50-50 odds (over time, profits and dividends usually increase).

Here's the catch, though. Human psychology being what it is, stock forecasters—and those who evaluate them—almost never factor these odds into their assessments of the forecasters' skills. (In 1998, when I suggested that Amazon's stock might eventually hit $400 a share, some media observers reacted with first shock and then adulation, as though the odds against this were 1,000-to-1; given the conditions at the time, I thought they were better than even). Similarly, those who buy stocks and make money almost never realize that a monkey should win about 50 percent of the time. Instead, they congratulate themselves on their acumen—they were right!—and double down. In a bull market, when the odds that the market, at least, will rise are even better than 2-in-3 (from 1982 to 1999, the S&P 500 rose 15 out of 18 years, or 83 percent of the time), most people forget their "mistakes" and increasingly come to believe that the next investing best seller should be titled George Soros, Warren Buffett, and Me.

This phenomenon of mistaking investing luck for skill infects every inch of the investment business, from investment banks to mutual funds to financial media to individual investors. It is also probably responsible for more losses and bankruptcies than any other market force since the dawn of time. No matter how carefully or how often the concept is explained, no matter how much evidence is provided to back it up, most people just can't accept that their investing success probably has more to do with luck than skill. Other people's? Maybe. Theirs? No way.

But forget for a moment all of the factors that influence stock prices. Imagine, instead, that the market is a coin. Assemble 1,000 people and tell them that, to assess their powers of prediction, you are going to flip the coin. When they protest—coin-flipping is unpredictable—lie to them. Say that your coin flips will be predictable. Say that some of them—those who whose powers of perception allow them to spot patterns and behavior others can't see—will be able to predict the flips with greater-than-average frequency. If there is no deliberation before the first flip (i.e., if no one makes a compelling argument about why the coin will land on one side or the other), approximately 500 people should call "heads" and 500 "tails." Flip the coin.

When the coin lands, post the names of the "winners" on a gigantic scoreboard. Call for a new round of predictions and flip the coin again. And so on. After five flips, the scoreboard should display the names of about 30 people who will have been right five times in a row, along with hundreds of others who have been right two or three times. If you were to conduct interviews, you would probably find people starting to believe that those on the scoreboard were better-than-average flip predictors. Flip some more.

After eight flips, you should have about four people with perfect records left. After nine, two. After 10, one. One person whose powers of prediction are apparently so acute that he or she has correctly called the coin an astonishing 10 times in a row. Assuming this person's success has been noticed after flips four, five, or six, you can imagine the accolades he or she might now receive, especially if, prior to every flip, he or she has explained the prediction ("The prevailing air currents, combined with the average height of the previous tosses and the average rate of the previous spins, will cause the coin to develop such momentum on the downside that, even if it bounces on tails, it will flip up and land on heads. … "). Everyone will want to know the genius' secrets—especially the poor sod who, via the same probabilities, will have been "wrong" every time.

In truth, of course, this savant isn't good: He or she is just lucky. From luck alone, one person in 1,000 should correctly predict a 50-50 outcome 10 times in a row—and, more important, 500 of the 1,000 should make the "correct" prediction half the time. The difference between the stock market and a coin is that, unlike coin flipping, the market seems inherently predictable (and, for some participants, it is—at least more predictable than a coin flip). Recall, however, that like a coin flip, the potential market "outcome" is binary. Recall that only a tiny fraction of the investors are right almost all the time. Recall that, to be a successful investor, you don't have to be right every time, or even most of the time—you just have to be right some of the time. And next time you hear a forecaster predict that the market is going to go up, remind yourself that if a monkey were making this prediction, it would usually be right.

This is not to say that all investing success is luck—it isn't. Some people are better than average, and, over time, some of them will generate superior returns. (According to John Bogle's Common Sense on Mutual Funds, approximately one in six mutual fund managers has enough skill to consistently beat the market after costs—1 in 6.) This skill, however, has little to do with the simplistic price predictions that dominate most market discourse. It stems from discipline, patience, experience, and methodologies that lead to a rare ability to determine when the odds are distinctly good or bad. Skilled investors aren't immune from losses—far from it. They are just talented enough that eventually, gradually, their skill allows them to win.

The consolation is that, if your time horizon is long enough, investing an appropriate percentage of your portfolio in stocks is smart. Unlike flying to Vegas or predicting coin flips, it is playing the odds.(As described here, over most 30-year periods, stocks have performed better than any other asset class.) Concluding that you or your favorite strategist/analyst/broker/friend/fund manager is "skilled" on the basis of a few good picks or years, however, isn't. It's very common, though. If you do it, you'll have plenty of company.

Next week: If there is so much luck involved in playing the market, what are stock analysts for?

Henry Blodget is the founder, editor, and CEO of Business Insider. Follow him on Twitter.

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