When it comes to investing, it’s important to understand the subtle difference between skill and luck in the investment process. Once you do, you’ll realize that successful investing requires a little bit of both. It will also become clear that not all good investments are based on skill and not all poor investments are the result of bad luck.

If you think of luck and skill as being on opposite sides of a continuum, investing falls closer to luck than skill. After all, investing, by nature, is based on probabilities not certainties. For example, if you take an action such as making an investment choice, is there a reasonable expectation for a different outcome than the one you hope to achieve? If so, then being successful at what you are doing likely requires a greater degree of luck.

Unfortunately, too many people who are overconfident in their ability as an investor find themselves mired in stock picking, market timing and chasing yield. As a result, they end up losing money and attribute it to bad luck and not a lack of skill. That’s why within your investment process, you must acknowledge the role that luck plays when designing your portfolio.

This is especially true when looking at the past performance of an investment (e.g. individual stock, bond or mutual fund). Why? The performance of any investment over time tends to move backward or forward toward its historical average, a process known as “mean reversion.” So, while the outcomes experienced by an investment may cause unexpected moves, it’s likely that its performance will smooth out over time. The key is to determine where the mean lies and whether it is stable or moving.

Obviously, trying to figure all this out is very difficult, even for a skilled investor. And because no one knows when the next outcome will occur or what it might be, I believe the concept of mean reversion reinforces the notion that luck—i.e., when to buy or sell an investment—plays an important role in portfolio construction.

NOTE:  Don’t let behavioral biases (fear and greed, anyone?) affect your investment decisions. Develop and stick to a process that applies rigorous analytics to and eliminates emotion from managing your portfolio.

Interestingly, big companies—like individual investors—are also subject to the vagaries of luck and skill when it comes to earnings. For example, is the successful launch of a product or service simply a matter of being in the right place at the right time (luck), or is it attributable to the vision and business savvy of the CEO (skill)? The reality is, probably both.

So, when you are evaluating a company as a potential investment, you need to take both into consideration. Also, you shouldn’t rely solely on the past performance of a company (see mean reversion above). That’s because hindsight only tells you what a company did in the past to become successful, not what they need to do in the future to remain so.

NOTE:  There is a quick test you can apply to the potential outcome of an investment decision that will help you determine if it is based primarily on luck or skill. Ask yourself if it is possible to lose the “bet” on purpose? If the answer is yes (taking a hit at Blackjack when you already have 20) then it is likely to involve more skill. If the answer is no (playing roulette) then the outcome is likely to involve a higher degree of luck.

Of course, it can be difficult to assess whether what you are doing is based on luck or skill because it’s human nature to think of positive outcomes as being based on skilled decisions and negative outcomes to be the result of “bad” luck.

To help ensure your investment decisions increase your probability of success in the long-run, you should develop and stick to an investment plan that acknowledges the role that luck and skill play in portfolio construction while understanding the difference between the two.

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David L. Blain, CFA, is president and chief investment officer of BlueSky Wealth Advisors, LLC, an independent registered investment advisor (RIA) doing business as D. L. Blain & Co. in New Bern, North Carolina and Pleasanton Financial Advisors in Pleasanton, California. You can contact David at davidblain@blueskywa.com.


Read another story by Blain here:

Retirement: Make the Right Assumptions

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