SIMON BROWN: Don’t get fooled by your own (bad) luck

I wrote back in June about how the price we pay is the only part of the investment process we control. I want to expand on that idea this week after I recently reread the book Thinking in Bets by Annie Duke.  

Duke is a professional poker player, which means she is in a world where plenty of skill and a lot of luck are required. It’s often very painful when you get a bad beat: you have great cards and you play them perfectly, but somebody pops up to win the hand after they played like a fool. This happens, but the trick is simple — stick to your game plan, because the person getting lucky will not win that often. 

In the investing and trading world we have a similar situation of luck, or bad luck, being able to play an outsize role at times. The problem is that we tend to focus on the making money part and use either a profit or a loss to decide whether our process was a good one. 

This is completely wrong, and here’s an example to illustrate what I mean. Let’s say there’s an almost bankrupt stock on the market and you decide to take a speculative position, as you think the company could turn things around. Instead, rather than the business being turned around, a buyout offer materialises, sending the price higher, and you make a profit. 

All well and good; but that profit came from luck, not your process. And process is what matters.

The other side of the coin is a position you take because you think the company is by miles the best in the sector, with strong growth and margins. You enter the position — but a few weeks later the CFO is arrested for stealing company funds and the stock collapses. You lose money, but that was totally beyond your process. 

The point is always to be focusing on your process and not the outcome. Your process you can completely control, but you have no control over the outcome — and it’s here that luck and/or bad luck can play a role. 

But if you have a strong process you will make a profit more often than not. 

This process is something you must continually refine and always be monitoring. After you close a position — or if it’s a long-term position, every year — check your process on that particular position. Why did you get in? What was your logic and expectations? Then, how is it going compared with what you expected; and should any deviance from your expectation be a concern? 

As we create strong processes we’ve refined over time on strategies such as value or growth, or even turnaround potential, we’ll be able to replicate winning trades far more often. 

This ability to replicate is what will ensure long-term success. If we're jumping all over the place looking for luck instead, in time we’ll go bust.