“What is luck, what is skill, and what is risk is one of the biggest problems we face when trying to learn about the best way to manage money,” Morgan Housel from Psychology of Money.
In Chapter 2 of Morgan Housel’s “Psychology of Money” he discusses how luck, risk, and skill factor into managing money. He gives numerous examples of how famous and wealthy people became who they are largely in part to falling on the right side of the very thin line between success and failure. As the great investor Benjamin Graham said, “One lucky break, or one supremely shrewd decision, can we tell them apart?”
Cornelius Vanderbilt and the Role of Luck
One example is Cornelius Vanderbilt and his railroad empire. In building his railroads, he would break the law repeatedly. Without hesitation. Ultimately, he wasn’t punished for this and became very successful. But what if the law did follow through and punish him like it had others? What if his company collapsed under the orders of the court? His story would be much different. He wouldn’t be in textbooks being described as a shrewd businessman or be an example of letting nothing stand in your way. He, instead, would be an example of what not to do. How trying to circumvent the law is a bad practice that will bring your business to its knees. Vanderbilt, we look at as a genius businessman, the other business leaders who were caught as frauds. They tried the same thing with different outcomes. Each took risks, one got lucky and avoided the law, while the other was ruined by it. Let’s be clear: it is never a good practice to try to circumvent the law, and it should never be recommended.
Distinguishing Luck from Skill in Personal Investing
When it comes to personal investing, it can also be hard to distinguish between luck playing a role versus being wise or taking an uneducated risk versus an educated one. Sometimes, making the most prudent financial decision doesn’t always pay off. For example, in many cases, it would be wise to diversify the company stock you own of your employer, assuming it is a large part of your net worth. Not only is it a concentrated position, but you also work for that company, so if things start to go badly for that company, not only could your employment and income be in jeopardy, but also the value of a large asset. In diversifying that stock, though, you could look back years later and see that the company stock outperformed what you diversified to. Did that outcome make it the wrong decision? I would say most likely not. The outcome doesn’t always determine the correct decision.
Many times, there is skill and luck when investing. Money managers don’t want to discuss the fact that luck can play a role in performance. This will hurt the confidence of the investors if they feel like the only way they make money is based on luck. Diligent research and understanding of what you own and why can help with making good financial investments. An area we consider when selecting an investment manager is their “batting average,” not just their 5 or 10-year return, which can sometimes be misleading. The reason is that some managers may have a return that outpaces their benchmark over 10 years, but when you dig deeper, they had one really good year that skews the results and then nine bad years. This would make you believe that maybe they got lucky that one year. Looking at the “batting average” of a manager, we can see how many times over that 10-year period were successful. The more times they outperformed, the more likely it was that prudent research and skill were involved in positive performance versus luck.
Your Misses Don't Derail Your Future
In closing, Housel recommends that your misses don’t derail your financial future. Make sure when you are taking a risk that it isn’t a risk that is more than you can afford. Because we don’t know the future and luck and risk can be involved, you can make a good decision and get a bad outcome. It is prudent, therefore, to understand the type and depth of risk you are taking with an investment or financial decision. This is often hard to do. At Provista, we have tools to help people understand how much risk they are taking and whether it is more or less than they are comfortable with. Even with luck and risk in this world, you are fully capable of making wise and proper financial decisions that, over time, will pay off. Remember the batting average. If you continually make wise financial decisions, you will be rewarded over the course of time, even if a few of them don’t turn out how you want. It takes effort, but in the long run, it is worth it.
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