Luck, randomness and skill…….

One of our long standing customers forwarded this article to me last year. It touches on a number of important topics that I believe are strongly related to active investing and are well worth being aware of to help put your trading endeavours into perspective.

http://www.smh.com.au/executive-style/culture/luck-of-the-draw-20120829-250hc.html

I’m sure that as you read this article all sorts of thoughts jumped into your head all energised by experiences that you have had in the past, some in agreement and some in disagreement with the article.

Allow me to comment on what I believe are the important take-aways from the article:

1. Before one can even get lucky there are some important facts for consideration that the article doesn’t cover:
   1. To get lucky, one must be in the game as an active player. Those sitting on the sidelines, watching, never get lucky.
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   2. To get lucky, one must do preparation. A quote by Gary Player: “The harder I practice the luckier I get”.
      1. “Luck happens when preparedness meets opportunity.” This quote sums up the first two points.
   3. Whatever you do, you should give your best efforts.

2. “Over the course of a long season, the best teams tend to win, and the worst to lose. But that is the product of a large sample: in the short run randomness reigns.” Michael Mauboussin.

   This is absolutely true with active investing. As Mark Douglas affirmed in his book, Trading in the Zone: “There is a random distribution between wins and losses for any given set of variables that define an edge.”

   Furthermore there is total uncertainty, due to randomness, in each individual event (=trade) but certainty can be achieved over a large sample of events (=trades) if one executes with a prepared edge.

3. “It turned out that “expert” players lost less money on bad hands;”

   This applies to poker, golf, business, trading and many things that we do in life. It’s not just about how much traders make on the winning trades, it’s so much more about how little they lose on the losing trades. Risk management is about keeping the loss situations to a minimum, both in quantity and size.  This is a key trait of good ‘players’ regardless of the environment in which they execute, be it the market, the golf course or the business world. Poor ‘players’ tend to compound bad ‘hands’ making the sitaution even worse.

4. “There’s a simple test for whether something is a game of skill: can you lose on purpose?”

   I find this statement quite profound. You certainly can lose on purpose in trading. Just ratchet up your position sizes, trade long in all market conditions, trade illiquid stocks and only buy stocks that are falling in price or not according to any researched process. A combination of these should do the trick!!

5. “… the difference between good and bad players may be visible in the long run, but most casual players (dabblers) of internet poker (or active investing), he says, the randomness plays a decisive role.”

   Randomness has been proven to be addictive to human beings. Their bias becomes the random win and the buzz that it produces thereby blinding them to the accumulative loss of the random losses. It drives ill-prepared investors to go for the big win by raising their stake on the low probability ‘roughie’ or outlier.

   Prepared investors learn what an ‘edge‘ is and prepare processes to capture opportunities that pass before their very eyes, never risking too much nor too little on each opportunity. They understand that randomness in the short run is normal and that certainty over a large sample is achievable with a prepared edge.

6. “Humans are obsessed with outcomes,” he says. “You have to distinguish the outcome from the decision process.”

   This is one of the most important take-aways from this article. Each outcome is independent from the next. There is no connection between outcomes from individual events except in our minds. How can you accept that each individual outcome is random (according to its statistical probabilities) and yet also think that the last loser will affect the next trade (shot in golf)? We make the connection in our minds and then feel either confident or unconfident! Let go of outcomes – establish and follow process! Especially those with a demonstrated edge.

7. “Almost all areas of life are plagued by randomness, but our story-loving brains find it almost impossible to see. ‘It takes a lot of discipline to think abstractly,’ says Mauboussin. ‘It’s amazing, in sport for instance (and trading), how few people – even coaches, or reporters – notice it…… we’re fooled by randomness all the time. The important thing is what we do about it.'”
   
   Beware of your story-loving brain. It will get you into trouble as you fall for a story that is outside of your prepared process. If you have no process it is easy to fall for a well told ‘story.’   “If you stand for nothing you will fall for anything.” Indeed, “it doesn’t matter what happens, it’s what we do about it that counts.” Sure, there are lots of things that happen that are important but once they have occurred we can’t change what’s happened. But we can react to what’s happened and how we react is far more important than what actually happens. Focus your energy and hours of preparation on how to react to circumstances rather than trying to avoid the circumstance in the future. Randomness will ensure a similar re-occurrence in the future, so put processes in place to handle what may happen. This is risk management.