The Most Important Thing Illuminated

Every once in a while, someone makes a risky bet on an improbable or uncertain outcome and ends up looking like a genius. But we should recognize that it happened because of luck and boldness, not skill.

The investment world is not an orderly and logical place where the future can be predicted and specific actions always produce specific results. The truth is, much in investing is ruled by luck. Some may prefer to call it chance or randomness, and those words do sound more sophisticated than luck. But it comes down to the same thing: a great deal of the success of everything we do as investors will be heavily influenced by the roll of the dice.

PAUL JOHNSON: For me the theme of this chapter is: Learn to be honest with yourself about your successes and failures. Learn to recognize the role luck has played in all outcomes. Learn to decide which outcomes came about because of skill and which because of luck. Until one learns to identify the true source of success, one will be fooled by randomness.

To fully explore the notion of luck, in this chapter I want to advance some ideas expressed by Nassim Nicholas Taleb in his book Fooled by Randomness. Some of the concepts I explore here occurred to me before I read it, but Taleb’s book put it all together for me and added more. I consider it one of the most important books an investor can read.

PAUL JOHNSON: I, too, am a huge fan of Nassim Taleb’s work, much of which Marks draws on for this chapter. I am particularly fond of Taleb’s concept of alternative histories, and Marks does an excellent job of incorporating this concept into his investment philosophy.

I borrowed some of Taleb’s ideas for a 2002 memo titled “Returns and How They Get That Way,” which incorporated excerpts from Fooled by Randomness, represented here by italics.

Thus, when considering whether an investment record is likely to be repeated, it is essential to think about the role of randomness in the manager’s results, and whether the performance resulted from skill or simply being lucky.

$10 million earned through Russian roulette does not have the same value as $10 million earned through the diligent and artful practice of dentistry. They are the same, can buy the same goods, except that one’s dependence on randomness is greater than the other. To your accountant, though, they would be identical. … Yet, deep down, I cannot help but consider them as qualitatively different.

Every record should be considered in light of the other outcomes—Taleb calls them “alternative histories”—that could have occurred just as easily as the “visible histories” that did.

If we have heard of [history’s great generals and inventors], it is simply because they took considerable risks, along with thousands of others, and happened to win. They were intelligent, courageous, noble (at times), had the highest possible obtainable culture in their day—but so did thousands of others who live in the musty footnotes of history.

Think about the aggressive backgammon player who can’t win without a roll of double sixes, with its probability of happening once in every thirty-six rolls of the dice. The player accepts the cube—doubling the stakes—and then gets his boxcars. It might have been an unwise bet, but because it succeeded, everybody considers the player brilliant. We should think about how probable it was that something other than double sixes would materialize, and thus how lucky the player was to have won. This says a lot about the player’s likelihood of winning again. …

In the short run, a great deal of investment success can result from just being in the right place at the right time. I always say the keys to profit are aggressiveness, timing and skill, and someone who has enough aggressiveness at the right time doesn’t need much skill.

At a given time in the markets, the most profitable traders are likely to be those that are best fit to the latest cycle. This does not happen too often with dentists or pianists—because of the nature of randomness.

The easy way to see this is that in boom times, the highest returns often go to those who take the most risk. That doesn’t say anything about their being the best investors.

Warren Buffett’s appendix to the fourth revised edition of The Intelligent Investor describes a contest in which each of the 225 million Americans starts with $1 and flips a coin once a day. The people who get it right on day one collect a dollar from those who were wrong and go on to flip again on day two, and so forth. Ten days later, 220,000 people have called it right ten times in a row and won $1,000. “They may try to be modest, but at cocktail parties they will occasionally admit to attractive members of the opposite sex what their technique is, and what marvelous insights they bring to the field of flipping.” After another ten days, we’re down to 215 survivors who’ve been right 20 times in a row and have each won $1 million. They write books titled like How I Turned a Dollar into a Million in Twenty Days Working Thirty Seconds a Morning and sell tickets to seminars. Sound familiar?

Thus, randomness contributes to (or wrecks) investment records to a degree that few people appreciate fully. As a result, the dangers that lurk in thus-far-successful strategies often are underrated.

Perhaps a good way to sum up Taleb’s views is by excerpting from a table in his book. He lists in the first column a number of things that easily can be mistaken for the things in the second column.

I think this dichotomization is sheer brilliance. We all know that when things go right, luck looks like skill. Coincidence looks like causality. A “lucky idiot” looks like a skilled investor. Of course, knowing that randomness can have this effect doesn’t make it easy to distinguish between lucky investors and skillful investors.

SETH KLARMAN: This is why it is all-important to look not at investors’ track records but at what they are doing to achieve those records. Does it make sense? Does it appear replicable? Why haven’t competitive forces priced away any apparent market inefficiencies that enabled this investment success?

But we must keep trying.

I find that I agree with essentially all of Taleb’s important points.

• Investors are right (and wrong) all the time for the “wrong reason.” Someone buys a stock because he or she expects a certain development; it doesn’t occur; the market takes the stock up anyway; the investor looks good (and invariably accepts credit).

• The correctness of a decision can’t be judged from the outcome. Nevertheless, that’s how people assess it. A good decision is one that’s optimal at the time it’s made, when the future is by definition unknown. Thus, correct decisions are often unsuccessful, and vice versa.

• Randomness alone can produce just about any outcome in the short run. In portfolios that are allowed to reflect them fully, market movements can easily swamp the skillfulness of the manager (or lack thereof). But certainly market movements cannot be credited to the manager (unless he or she is the rare market timer who’s capable of getting it right repeatedly).

• For these reasons, investors often receive credit they don’t deserve. One good coup can be enough to build a reputation, but clearly a coup can arise out of randomness alone. Few of these “geniuses” are right more than once or twice in a row.

Most people acknowledge the uncertainty that surrounds the future, but they feel that at least the past is known and fixed. After all, the past is history, absolute and unchanging. But Taleb points out that the things that happened are only a small subset of the things that could have happened. Thus, the fact that a stratagem or action worked—under the circumstances that unfolded—doesn’t necessarily prove the decision behind it was wise.

Maybe what ultimately made the decision a success was a completely unlikely event, something that was just a matter of luck. In that case that decision—as successful as it turned out to be—may have been unwise, and the many other histories that could have happened would have shown the error of the decision.

One of the first things I remember learning after entering Wharton in 1963 was that the quality of a decision is not determined by the outcome. The events that transpire afterward make decisions successful or unsuccessful, and those events are often well beyond anticipating. This idea was powerfully reinforced when I read Taleb’s book. He highlights the ability of chance occurrences to reward unwise decisions and penalize good ones.

What is a good decision? Let’s say someone decides to build a ski resort in Miami, and three months later a freak blizzard hits south Florida, dumping twelve feet of snow. In its first season, the ski area turns a hefty profit. Does that mean building it was a good decision? No.

A good decision is one that a logical, intelligent and informed person would have made under the circumstances as they appeared at the time, before the outcome was known. By that standard, the Miami ski resort looks like folly.

As with risk of loss, many things that will bear on the correctness of a decision cannot be known or quantified in advance. Even after the fact, it can be hard to be sure who made a good decision based on solid analysis but was penalized by a freak occurrence, and who benefited from taking a flier. Thus, it can be hard to know who made the best decision. On the other hand, past returns are easily assessed, making it easy to know who made the most profitable decision. It’s easy to confuse the two, but insightful investors must be highly conscious of the difference.

HOWARD MARKS: Fear of looking wrong: It’s counterintuitive but extremely important: given the randomness and variability at work in our environment, it’s often true that good decisions fail to work and bad decisions succeed. In particular, investors are “right for the wrong reason” (and vice versa) all the time. You mustn’t let this frustrate you and convince you your good decisions were mistakes (unless so many prove wrong that you have to consider that possibility).

Since the investors of the “I know” school, described in chapter 14, feel it’s possible to know the future, they decide what it will look like, build portfolios designed to maximize returns under that one scenario, and largely disregard the other possibilities. The suboptimizers of the “I don’t know” school, on the other hand, put their emphasis on constructing portfolios that will do well in the scenarios they consider likely and not too poorly in the rest.

Investors who belong to the “I know” school predict how the dice will come up, attribute their successes to their astute sense of the future, and blame bad luck when things don’t go their way. When they’re right, the question that has to be asked is “Could they really have seen the future or couldn’t they?” Because their approach is probabilistic, investors of the “I don’t know” school understand that the outcome is largely up to the gods, and thus that the credit or blame accorded the investors—especially in the short run—should be appropriately limited.

The “I know” school quickly and confidently divides its members into winners and losers based on the first roll or two of the dice. Investors of the “I don’t know” school understand that their skill should be judged over a large number of rolls, not just one (and that rolls can be few and far between). Thus they accept that their cautious, suboptimzing approach may produce undistinguished results for a while, but they’re confident that if they’re superior investors, that will be apparent in the long run.

Surprisingly good returns are often just the flip side of surprisingly bad returns. One year with a great return can overstate the manager’s skill and obscure the risk he or she took. Yet people are surprised when that great year is followed by a terrible year. Investors invariably lose track of the fact that both short-term gains and short-term losses can be impostors, and of the importance of digging deep to understand what underlies them.

Investment performance is what happens to a portfolio when events unfold. People pay great heed to the resulting performance, but the questions they should ask are, Were the events that unfolded (and the other possibilities that didn’t unfold) truly within the ken of the portfolio manager? And what would the performance have been if other events had occurred instead? Those other events are Taleb’s “alternative histories.”

JOEL GREENBLATT: The best-performing mutual fund for the decade of the 2000s made 18 percent per year. The average (dollar-weighted) investor in the fund lost 8 percent per year during this same period. Investment inflows followed “up” performance, or outperformance and outflows followed losses or underperformance. Apparently, there was little long-term assessment of investment skill by most investors when making allocation decisions.

The actions of the “I know” school are based on a view of a single future that is knowable and conquerable. My “I don’t know” school thinks of future events in terms of a probability distribution. That’s a big difference. In the latter case, we may have an idea which one outcome is most likely to occur, but we also know there are many other possibilities, and those other outcomes may have a collective likelihood much higher than the one we consider most likely.

HOWARD MARKS: Understanding uncertainty: People who think the future is knowable (and that they can know it) belong to what I call the “I know” school. They ignore the presence of uncertainty and act in ways that will increase profits if they’re right but expose them to increased losses if they’re wrong. Recognizing this, it’s important for all investors to figure out whether they know and act accordingly.

• We should spend our time trying to find value among the knowable—industries, companies and securities—rather than base our decisions on what we expect from the less-knowable macro world of economies and broad market performance.

• Given that we don’t know exactly which future will obtain, we have to get value on our side by having a strongly held, analytically derived opinion of it and buying for less when opportunities to do so present themselves.

• We have to practice defensive investing, since many of the outcomes are likely to go against us. It’s more important to ensure survival under negative outcomes than it is to guarantee maximum returns under favorable ones.

• To improve our chances of success, we have to emphasize acting contrary to the herd when it’s at extremes, being aggressive when the market is low and cautious when it’s high.

Several things go together for those who view the world as an uncertain place: healthy respect for risk; awareness that we don’t know what the future holds; an understanding that the best we can do is view the future as a probability distribution and invest accordingly; insistence on defensive investing; and emphasis on avoiding pitfalls.

Luck	Skill
Randomness	Determinism
Probability	Certainty
Belief, conjecture	Knowledge, certitude
Theory	Reality
Anecdote, coincidence	Causality, law
Survivorship bias	Market outperformance
Lucky idiot	Skilled investor