What’s luck got to do with investing?

How do I define history? It’s just one f*%&ing thing after another.
— Rudge in Alan Bennett’s The History Boys

I came across this sentence last night and it’s been haunting me ever since. It reminds me of a situation which I encounter almost everyday: “What’s the story?” my editor(s) ask, when I make a pitch to them about something I want to write on.

Well I don’t blame them for asking the same question over and over again. After all, newspapers are in the business of making sense of what is happening around us. But are we really doing that? Or to ask a deeper question, can we really do that?

Take the case of the BSE Sensex rallying by a little more than 500 points on December 23. Now why did it happen? If newspaper reports are to be believed (including this newspaper), the market went up because the finance minister revised the GDP growth rate to between 7.5% and 8%.

Sounds reasonable? Yes. Or does it?  The FM has made such noises of the economy doing well in the past as well. Has the market rallied to such an extent, every time he has said something optimistic? Or has it rallied to the extent it rallied on December 23?

Or was it, to put it a little more realistically, a case of investors getting up on the right side of the bed, and in the pre-Christmas good mood, going out and buying stocks, and thus pushing up prices? The point is, I don’t know. But I can’t say that to my editor. We are in the business of explaining things. (In fact, the word analysis is even built into our paper’s name). And that’s what I do on an occasion like this; I try and create a story which explains things.

John Allen Paulos explains this phenomenon in his extremely engaging book A Mathematician Plays the Stock Market: “Around stock market rises and declines, people are often prone to devise just-so-stories to satisfy various needs and concerns.”

Having said that, what would be the correct way to report on such events? Nassim Nicholas Taleb, before he became famous for writing Black Swan, wrote a much better book called Fooled by Randomness. In this book, he elaborates what he feels should be a true role of a journalist. “To be competent, a journalist should view matters like a historian, and play down the value of the information he is providing, such as by saying: ‘Today the market went up, but this information is not too relevant as it emanates mostly from noise.’”

Now, have you ever come across a story, article or column in a newspaper that says just that? Of course not! Anybody trying to do that is more likely to lose his job, as Taleb puts it “by trivialising the value of information on his hands.”

This inherent need to construct a story around events leads to several other interesting situations. The media likes heroes. We create them now to destroy them later.
Take the case of someone like a Rakesh Jhunjhunwala in India, or a Warren Buffett in the US. Are they really as competent as they are made out to be or does luck play a huge part in their success?

As Taleb writes, “If one puts an infinite number of monkeys in front of (strongly built) typewriters, and lets them clap away, there is a certainty that one of them would come out with an exact version of the Iliad… Now that we have found that hero among monkeys, would any reader invest his life’s savings on a bet that the monkey would write the Oddsey next?”

The investors we love to write about are survivors who have had a lucky winning streak of generating greater returns than the broader market over the years.

As Malcolm Gladwell explains in his new book What the Dog Saw and Other Adventures, “Suppose that there were 10,000 investment managers out there, which is not an outlandish number, and that every year half of them, entirely by chance, made money and half of them, entirely by chance, lost. And suppose that every year, the losers were tossed out and the game was replayed with those who remained. At the end of five years, there would be three hundred thirteen people who had made money in every one of those years, and after 10 years, there would be nine people who had made money every single year in a row, all out of pure luck.”

Leonard Mlodinow, a faculty at the California Institute of Technology explains this phenomenon rather succinctly: “a simple calculation shows that if a the few thousand mutual fund managers who were managing funds… were simply flipping coins once a year, rather than investing in the market, and if we equated getting ‘heads’ with beating the S&P, then after a few decades, the chances of a streak of ‘beating the S&P’ for 15 or more years in a row would be 75%.  This illustrates that a streak like this was to be expected, by chance alone, and hence does not indicate skill.”

A good example of a person who rode this phenomenon is a mutual fund manager called Bill Miller whose Legg Mason Value Trust mutual fund — one of the biggest mutual funds in the world — beat the returns of S&P 500 Index for 15 consecutive years from 1991 to 2005.

Tomes got written on his legendary investing style and various reasons got attributed to his success. But Mlodinow feels Miller was plain lucky. And his performance regressed to the mean once the current financial crisis had an impact on the performance of his fund. As Michael J Mauboussin, Miller’s colleague at Legg Masson, writes in his new book Think Twice, “We have difficulty in sorting skill and luck in lots of fields, including business and investing.”

Over and above this, because these guys are famous, other investors follow their investing decisions, buy when they buy, and sell when they sell. This makes these investors look even more smarter than they are. As Paulos writes about Warren Buffett: “His phenomenal success… is often cited as an argument against the market’s randomness. This assumes, however, that Buffett’s choices have no effect on the market. Originally no doubt they didn’t, but now his selections themselves… can influence others. His performance is therefore a bit less remarkable than it first appears.”

At times, investors themselves come up with stories and theories regarding their investment decisions. George Soros, the hedge fund manager, who once broke the back of the British pound, is said follow the Theory of Reflexivity, which was influenced by the work of the philosopher Karl Popper (who said and as Gladwell states in his new book, “You could not know with any certainty that a proposition was true; you could only know that it was not true”), while making his investment decisions.

But as Robert Soros once said about his more famous father, “My father will sit down and give you theories to explain why he does this or that. But I remember seeing it as a kid and thinking, Jesus Christ, at least half of this is bullshit. I mean, you know the reason he changes his position on the market or whatever is because his back starts killing him. It has nothing to do with reason. He literally goes into a spasm, and it’s this early warning sign.”

Luck plays a much more important role in the investing process than people (which include journalists like me) are ready to admit. But if we in the media start attributing luck and noise to every time a market moves, or an investor does well, what will we ever write about? And we need our headlines, because headlines sell what we write, though they never tell you the real story.

As Taleb summarises it best “People do not realise that the media is paid to get our attention. For a journalist, silence rarely surpasses any word.”