Wednesday, April 4, 2012

Skill v/s luck in investing - the eternal debate

I am very sure that we all have been part of this debate at one time or another in our investing lives. In my experience, the more drunk the participants, the more lively is the debate! :-)

There are some who really believe in their own prowess and opine that skill is the only factor which dictates success in investing. Well, perhaps these people have been fooled by randomness or have never been hit by a black swan event. These people should really read Taleb. :-)
There are others who say that investing is as good as (or as bad as) gambling. They opine that performance in investing is a matter of sheer luck. Believers in the Efficient Market Theory would surely say that if you are outperforming the market, it is only because you have been lucky. Well, these people should read Buffett! :-)

In my view, the answer lies somewhere in between and is a combination of luck and skill. Its like marriage. One would be lucky to get a good wife, but one has to be skillful so that she remains good to you! :-) Success in investing is a matter of luck as well as skill. However, the percentage of both differs in different situations.
E.g. There is skill involved in earning money as well as in not losing money. So if you avoided something bad, thats skill too. On the other hand, many times, one earns money by luck too.

But in my experience, here is what most people do. If they make money, its all skill, but if they lose money, its all bad luck!! I don't think thats a very great way of approaching things. Crediting skill when we make money leads to overconfidence and stupid decisions in future. Blaming luck when you lose money does not let us introspect and correct our mistakes since we think that we did not make a mistake, it was just bad luck!

Let me share a couple of my experiences with you.

1) Albright Chemicals (now, Rhodia Specialty Chemicals)
Albright was not an extraordinary business. But still, I had bought it for a specific reason. The company was available at a market cap of about Rs.50 cr. (Today its Rs.126 cr). The company had also published an advertisement for selling their land in Ambernath. The 26 acre piece of land would be worth about Rs.50 cr. Now, since it was very clear that they wanted to sell this land, its value becomes material. I thought the business to be worth Rs.45-50 cr plus the land worth Rs.50 cr more, giving a valuation of Rs.80 cr, after deducting Rs.20 cr if debt. So, something worth Rs.80 cr was available for Rs.50 cr. Decent logic, I felt, and I bought the stock.
After some time, suddenly, Solvay acquired Albright's parent, triggering an open offer. The stock price reacted and I sold at a decent profit.
Now, the question is, was this skill or luck? I believe the end result was a matter of pure luck. I had bought it primarily because of expectation of land sale, leading to increased valuation for the stock. The price did increase, but for a different reason. The land still remains unsold!! So, even though the end result was as per expectation, the reason for the end result were not as per expectation. Now, thats luck, wont you say?

So, in my view, if you bought something with certain expectations, and in future, the expectations materialised just as per your view, due to which you earned the desired profit, then its skill. Otherwise, even if you earned the profit, its all luck!

2) Provogue Ltd.
Boy, was that an adventure or what! :-) Although, I must say that it was not a very comfortable adventure! I did earn decent returns here, but it was all pure dumb luck. Absolutely no doubt about it!
The reasons why I bought the stock can be found here.
After some time, due to some changes which occurred in the situation, I decided to sell it before ex-date.
Now, all that I had thought would happen, did not happen!
- I had thought that on ex-date, the stock price wont fall much. Maaan, it fell huge!
- The reason I sold, was that relisting of Provogue could take lot of time..but it got relisted pretty fast.
- Creating free shares of Prozone was the main reason for getting into Provogue. That, it seems, would not have happened! :-)
So, absolute dumb luck it is!

There are other cases where I think I applied decent amount of skill..but there is no fun in talking about success stories, right? :-)

So all in all, we should always remain grounded, with understanding of the reality that luck does play a role in investing. Luck is something we cannot control, but skill is something we can develop. Let us all concentrate on that but not consider ourselves to be exceptionally skilled just because we earned money. If we do that, there would be no room for self-improvement.

On the same topic, me and my friend Ninad often discuss about the idea of positioning yourself for luck. If you can get yourself in situations where multiple lucky things can happen to you or no un-lucky thing can happen, that would be really something! But, that would be a topic for a separate post, I hope!

Till then,

Cheers and happy-go-lucky investing! :-)

39 comments:

Kaushal said...

the best way to be lucky is to be skilled

Neeraj Marathe said...

Good one! and i honestly wish it were true!
Cheers!
Neeraj

Neeraj Marathe said...
This comment has been removed by the author.
jigs said...

Albright might have given ADV because open offer was coming :-).
But finally its all luck I think. Some of my genius friends who started investing/trading career just 6-7
years back if they were to start their career in 1990-1991 they would have beaten RJ, RD, NS hands down in creating wealth by now. My friends are genius BUT they are not lucky :-).

Neeraj Marathe said...

Its all luck? Jigs, yaar, dont say that..mere clients bhaag jayenge! :-)
cheers!
Neeraj

Anup PAtil said...

What a coincidence!! I am reading fooled by randomness and about to finish it this weekend and couldn't make up my mind whether I am lucky or skilled in last 4 years of my investing and now after reading this I am more confused ;);) but nice peace :)

Abhi said...

This topic is as you said always point of discussion.
I agree with positioning for luck theory/practise (I think we might have spoken a bit on this). This concept is simple to understand yet very difficult to get ingrained and I find it very difficult to explain to someone. You spread your bets on misunderstood (temporarily) asset but solid enough that gives downside protection and hopefully someone comes along to value it correctly (either by open offer or driven management going in for unlocking value or activist investor or any other trigger). So in your case of albright chemicals, the trigger was land value sale , that the management decided to do, but trigger came from open offer. But the important thing was that you bet on asset that had probably had less downside and positing itself for unlocking the value. It was matter of time someone unlocked it. Of course, at times trigger does not come as expected or take too long time to execute and value never gets realized in terms of expected return.
I would say skill part is in understanding and executing the ‘positioning yourself for luck’ practise and luck is when value gets realised. I would say it is essence of value investing portfolio management.
Ofcourse there are areas where this is difficult to work. For instance, Apple was 1 billion dollar a quarter company in 2003/04. It is now 100 billion dollar quarterly company. The growth is phenomenal and unprecedented. It was difficult in 2004 to see apple launching 3-4 hit one after another. I didnot put money in it. My friend was believer he put it in and become multibagger for him. Now that was pure luck.

Neeraj Marathe said...

Thnx Abhi,
I agree with you..
cheers!
Neeraj

Anonymous said...

Excellent write up!

Luck,Randomness and complexity are things that can morph a picture beyond our comprehension.

What do we know?

What do we think we know?

What do we not know?

What cannot we know?

What is more important,the stuff we know or the unknown?

The power law,where the extreme and the rare have a disproportionate impact on an outcome as Taleb has pointed out in his book makes averages pretty much meaningless,a single event can make or break everything.

Good Luck:)
Krishna

Anonymous said...

Good thought process to keep oneself from committing mistakes due to overconfidence....
would love to hear your thoughts on what's the right time (and capital) to start "full time investing" career on your own???

Dayanand Deshpande said...

Good thoughts!! the thought process helps you keep away from "overconfidence" bias...I like it!

Would like to know your thoughts on what's the correct time (and capital) to start being a full-time investor managing your money...??

Wishbone said...

Hi,

I read somewhere that luck is an indirect form of probability. If you keep on trying continuously the probability of you getting success improves.

So hopefully, we keep following the process diligently are probability/luck improves.

cheers,
saurabh

Neeraj Marathe said...

Hello DD,
Ya, I firmly believe that humility is a must in investing. Overconfidence does not help.
Regarding the 2nd part, I feel that when one reaches a stage where ones day to day expenses for living comfortably are taken care of come what may, its a great time to start on ur own. Luxuries are optional and never ending. The basic lifestyle should not be compromised.
Cheers!
Neeraj

Neeraj Marathe said...

Thnx Krishna.. agreed totally.
Cheers!
Neeraj

Neeraj Marathe said...

Hi saurabh,
It's just that one should not go bankrupt trying continuously! :)
Cheers
Neeraj

Dhwanil said...

Hi Neeraj,

As usal, awesome post combining skill of writing and thinking both!

In my opinion, the skill part is about orienting investing decisions such that majority of such decisions minimizes one's odds of losing money, that is ensuring at least safety of capital under worst case scenario (margin of safety).

However, out of such opportunities, if you get a 10 or 20 bagger, it is more likely to be due to luck. However,probability of finding such "lucky" opportunities may be more if you apply skill in selecting opportunities where odds of losing money is minimum.

According to Prof. Sanjay Bakshi, "Serendipity" plays a big role in investment success.

Best Regards
Dhwanil Desai
http://valueinvestinginpractice.blogspot.in/

Neeraj Marathe said...

Thnx Dhwanil,
Totally agree with you..and thats why we should use the value investing and MOS principles as much as possible..
cheers!
Neeraj

Neeraj Marathe said...

Thnx Anup..Fooled by Randomness is indeed an excellent book..
cheers!
Neeraj

sameer said...

very much relevant to this post and from very experienced man(to whom I track closer than even Charlie Munger)
http://www.valuewalk.com/2012/04/michael-mauboussin-cfa-conference-skill-risk-and-luck/

Ankur Jain said...

A very senior value investor once shared his formula in investing with me. KCP LTD

K-Knowledge
C- Conviction
P-Patience
L- Luck
TD- Timely Decision

Fits brilliantly in your example too :-)

You had knowledge about the land sale in Rhodia. I mean you read in the newspaper. You had conviction in the value and so you went ahead and bought the stock. You had patience to wait for something good to happen. You were to lucky to see Solvay coming your way. You decided to sell the stock in time.

Neeraj Marathe said...

Haha.. KCP LTD is real good. :)
Thnx Ankur.
Cheers
Neeraj

Anonymous said...

Hi Neeraj
How do you study annual reports? These days they dont come in hard copies (available only as soft copies). It is painful to read on the computer. Do you print them or ask for hard copies - especially when you are not a shareholder - how do you get hold of annual reports?
regards

Neeraj Marathe said...

Hello Anon,
Ya i agree that reading soft copies isnt too much fun!
We have bought 5 shares each of over 300 companies, just for AR purposes.
In other cases, if needs be, i do print the report..
cheers!
Neeraj

Anonymous said...

that's a great idea. still when we need past few years ARs we need to print I guess.
thanks yaar

Anonymous said...

What are your thoughts on State Bank of Mysore,do you feel the merger with SBI will happen before June'13 given that they will need to comply with the shareholding norms?

Regards,
Anil

Neeraj Marathe said...

i do not think it will happen so fast..
Cheers!
Neeraj

Vishal Kejriwal said...

Hi Neeraj

I have two Questions regarding Right issue

1. Is promoter of company is also eligible for right issue?
2.Now suppose i am eligible for 10 right issue share and have requested for some extra allotment of 1000 shares, whether there is any chances i get in between 10 to 1010.

Thnaks
Vishal

Vishal Kejriwal said...

Hi Neeraj

I have two Questions regarding Right issue

1. Is promoter of company is also eligible for right issue?
2.Now suppose i am eligible for 10 right issue share and have requested for some extra allotment of 1000 shares, whether there is any chances i get in between 10 to 1010.

Thnaks
Vishal

Vishal Kejriwal said...

Hi Neeraj

I have two Questions regarding Right issue

1. Is promoter of company is also eligible for right issue?
2.Now suppose i am eligible for 10 right issue share and have requested for some extra allotment of 1000 shares, whether there is any chances i get in between 10 to 1010.

Thnaks
Vishal

Neeraj Marathe said...

Hello Vishal,
yes, the promoters are also eligible to apply for rights issue.
How much allotment you will get is a question which you cannot answer with any certainty..so cant say really
cheers!
Neeraj

Vishal Kejriwal said...

Hi Neeraj,

Thanks for clearing my previous doubt.

I have another doubt
Today is record date for the Arihant Super and stock is down more than 30% in early date.
Now my doubt is as this in not F&O stock even no bonus or split decelartion so maximum lower circuit limit can be 20%.

please clarify me on same.

Regards,
Vishal

Neeraj Marathe said...

Hi Vishal,
Sorry, i missed replying to your query. May i please request you to put your comments in the relevant post, so that i dont miss them..
regarding circuit, the exchange adjusts the price post rights and then puts a 20% circuit on it. So ex-rights adjusted price of arihant would be 57-58, on which a 20% circuit is put.
cheers!
Neeraj

Vishal Kejriwal said...

Thanks neeraj for clarifying my doubts.

Next time i will take care and put requested questions in correct thread

Thanks
Vishal

Neeraj Marathe said...

Thanks Vikas,
Cheers!
Neeraj

Neeraj Marathe said...

Thnx a lot..glad you liked it..
cheers!
Neeraj

Alok Katre said...

Well if "didi" (Mamta Banerjee, for the uninitiated) can claim 99% hard work Kane 1% luck, I am sure You can claim at least 70% hard work, can't you. But then that wouldn't be being yourself will it. You are too modest, my dear friend. Need a few moe Iike you ;-)

Neeraj Marathe said...

Haha..thanx man, but we all know that in the market, luck plays a more important role than in areas like, lets say, politics!
cheers!
Neeraj

Upasana said...

It is very impressive piece of writing. & I believe from now onwards i will surely differentiate the 2.
I hav't read about buffet's success theory till yet but yes i hav read about rakesh jhunjhunwala on wikies.
Don't u think earlier it was a bit easy to earn money becas at that time most of the companies were at growing stage or gov policy were very much in favor.
now the things are change,we cannot think the way they did. The scenario is totally changed. big issues like rupee fluctation, inflation, deficits very interlinked terminologies ........where to start and where it ends.

Neeraj Marathe said...

Well put m'am..
but at any stage in a market or an economy, you will always have companies which are growing/undervalued and are great opportunities for investment. the big deal is to spot them and to buy material quantities of the shares.
I agree that the macro factors are changing rapidly these days..however these are out of our control and we cant predict them. so better not to give them much thought..concentrating on individual companies works best..
cheers!
Neeraj