Examining How “Luck o’ the Irish” Impacts Investing

It’s that time of year. The Chicago River has been dyed. Bars across the country are preparing for green glitter-saturated pub crawls. For one day, everyone is Irish and hoping to capture a little of that storied luck.

The concept of luck often draws scorn among seasoned investors. They insist that investing luck has nothing to do with why they get ahead. From picking stocks to founders, financial professionals will tell you that leveraging the combination of experience, expertise, and skill is how they get results.

But is it really? Or do we just tell ourselves that to feel like we have a little control over the sprawling, complex world of investing?

A Crisis of Confidence in the Wrong Direction

The idea of “striking it lucky” in the market has been around since the beginning of trade. Discussions on the subject tend to revolve around timing. 

He’s lucky he got in when he did, they’ll say. It was a stroke of luck that he got out of that position when he did.

For advisors and fund managers, such assertions may come off as insulting. After all, their entire value proposition rests on the idea that they can provide alpha – or an excess return above that of an established benchmark like the S&P 500 or a model portfolio. 

To say that purported alpha hinges on luck undermines their entire sales pitch –  not to mention any ego involved. The same goes for individual investors who are often “long confidence and short experience.”

Monkeying Around with Data on Investing Luck

Investors and professionals offended by insinuations that they’re “just” lucky have an uphill climb in defending themselves. The hurdle? Actual data.

You might be familiar with the famous quote from American economist Burton Malkiel’s seminal book A Random Walk Down Wall Street, first published in 1973:

A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts.

That’s a bold claim. It might also be true. Some research indicates that – quite literally – a blindfolded monkey can do better at stock picking than an individual investor. As analyst and author Rick Ferri reported in 2012:

“Malkiel was wrong,” stated Rob Arnott, CEO of [investment advisory firm] Research Affiliates, while speaking at the IMN Global Indexing and ETFs conference earlier this month. “The monkeys have done a much better job than both the experts and the stock market.”

In their yet-to-be-published article, the company randomly selected 100 portfolios containing 30 stocks from a 1,000 stock universe. They repeated this [process] every year, from 1964 to 2010, and tracked the results. The process replicated 100 monkeys throwing darts at the stock pages each year. Amazingly, on average, 98 of the 100 monkey portfolios beat the 1,000 stock capitalization weighted stock universe each year.

Not exactly a great look. How are “experts” (or anyone else, for that matter) supposed to claim an advantage when a primate with a dartboard has a significant chance of beating them? 

The Investing Luck Odds Don’t Add Up

Monkey business aside, experts have studied the role of luck in investing for years. Most of this research examines stock-picking success to measure the influence of luck on investing outcomes. 

One 2014 study from J.P. Morgan calculated the odds that any single stock pick would deliver outsized positive or negative returns. The analysis assessed individual stock performance in the Russell 3000 index over a period of 34 years relative to the performance of the overall index. 

They found that only 7% of individual picks were “extreme winners” – meaning they outperformed the index. On the other side of the equation, 64% of stock picks delivered excess negative returns. Most alarmingly, 40% of stock picks experienced a “catastrophic loss” – a drawdown of 70% from their peak value.

The study demonstrates how difficult it can be to consistently pick winners, let alone a portfolio full of them. But research in behavioral finance suggests that the average investor’s odds are further compromised by their own psychology. Over-confidence combines with factors like poor or incomplete information, the drive to chase returns, loss aversion, and a bias towards the familiar to yield suboptimal results. 

Investing Luck Has Nothing to Do with It: Experts and Alpha

Not all research supports the contention that investing success relies on luck. In fact, there’s evidence that experts may have an edge, after all. 

A study published in the 2013 Graziado Business Review evaluated the performance of stock portfolios shaped by the recommendations of top-rated financial analysts across the industry. Not only did each of their portfolios deliver alpha, but a model combining all of the guidance in a single portfolio outperformed each individual one. 

Experts might enjoy an edge due to some of the same reasons the average individual does not. Most professionals have access to high-level data and analysis – and more of it. When combined with the experience and knowledge necessary to parse it, this quality information may better position investors and advisors to act prudently.

Many professionals rely on systems designed to limit the impact of human bias, as well. This is especially true of institutional investors and hedge fund managers. The portion of hedge funds using algorithms to trade 80% of their total value traded jumped from 10% in 2020 to 20% in 2021. It’s a trend that’s not slowing down. 

Banking on Investing Luck: a Risky Proposition

Much of the research tied to luck uses simple analysis to make a point. In reality, most investors don’t actively manage their own investment portfolios. Their allocations are also far more diverse than a model stock portfolio, including exposure to different asset classes and risk levels. 

This is where expert performance may differ from non-professional investors. It’s not just that no professional worth their salt would ever tell you to put all your eggs in an equities basket. They understand the complexities involved in developing a balanced, diversified investment portfolio tailored to the risk tolerance, available risk capital, and financial goals of an individual. 

Putting professionals like hedge fund managers to the side, that’s what separates monkies from the all-stars. They have better information. They have systems and processes designed to guide their decision-making. But thanks to their experience and ability to focus on individual needs and capacity, they can tailor portfolio construction to address specific profiles.

Could AI Replace Both Investing Luck AND Skill?

On the heels of the recent GPT-4 launch, we would be remiss in not considering whether AI like ChatGPT could make conversations about luck v. skill irrelevant. After all, the fever pitch of conjecture on AI’s risks and benefits has been all but deafening.

We’ve written before about the limitations of AI in financial applications. In many ways, experts hold an advantage of AI for the same reasons that they beat out randomized stock-picking models. They offer a human overlay requiring qualitative evaluations of an individual that the systems behind AI struggle to replicate.

Current AI limitations have been demonstrated through a number of experiments. When asked to identify the top-performing ETF guided by AI, ChatGPT couldn’t name one – even though plenty exist and many were named using keywords associated with the query. MarketWatch found it able to answer questions about investment principles but woefully deficient in performing tasks involving investment intelligence. In both cryptocurrency and stock portfolios, AI mirrors many conservative financial advisors, preferring historically strong performance and high volume.

This is perhaps unsurprising. AI “learns” through accessing existing available data. It may tell you that past performance is not necessarily indicative of future results, but its portfolio modeling relies on it. In volatile markets or “black swan” events, that’s a problem. 

And ChatGPT will be the first to tell you it’s not up to the job. Bloomberg asked it to “design an ETF to beat the US stock market and tell us what stocks are in it. This was the reply:

Source: Bloomberg

Feeling Lucky?

Maybe St. Patrick’s Day has you thinking about rolling the dice on your own investment picks. We get it. There are certainly experts out there who would tell you that the luck you experience today or any other day represents an uncomfortable reality. As legendary distressed asset investor Howard Marks once put it:

The truth is that in investing, luck largely rules. Some may prefer to call it chance or randomness, and these words sound more sophisticated than luck. But the point is the same: a large part of the success of everything we do as investors is largely determined by the roll of the dice.

Maybe he has a point. The data, however, indicates that betting on luck winning the day is ill-advised. If you really want to get lucky, you’ll make your own. Stop chasing leprechauns and engage with a professional. It’s a much more likely path to the pot of gold at the end of the investment rainbow.

Those who want to buck luck and computers in favor of smarter investing stand to benefit from learning more about options and strategies. The following on-demand webinars from Financial Poise offer a great starting point:

• All About Asset Allocation
• Goal-Based Investing – Planning for Key Life Events
• Alpha, Beta, and Other Key Concepts

And there’s more where that came from! For more information about our on-demand webinar series, click here.

©2023. DailyDAC^TM, LLC d/b/a/ Financial Poise^TM. This article is subject to the disclaimers found here.