Luck and skill have a role to play in investment success

A well-known dictionary defines luck as ‘a force that brings good fortune or adversity.’ Individuals typically attribute success to their skills.

The behaviour of attributing success to skill and failure to bad luck is called self-attribution bias. In this article, we discuss how such biases shape our attitude towards luck in our personal finance.

Success versus skill

If skill is all it takes to be successful, why are many not-so-skilful individuals rich and why are so many brilliant and skilful ones having a boring day job?

It is natural to attribute success to skill and hard work, and failure to laziness, especially when the latter relates to someone else. The fact is that luck is an integral part of everyone’s success. You could become overconfident when you suffer from self-attribution bias, taking more investment risk than is required. Self-attribution bias also leads to hindsight bias.

This refers to our behaviour to look back at your decisions and believe that the events were predictable. Hindsight bias could prompt us to attribute a successful outcome to our skill of having predicted the event correctly.

The issue is that luck has two sides. Risk is the possibility that your seemingly good decision can have an adverse future outcome (bad luck?).

Good luck (often attributed to skill) is when a seemingly bad decision turns into a positive outcome. The point is that we rarely consider a decision as bad when we experience a positive outcome. So, the role of luck is rarely acknowledged in investment success.

Adjusting investment calls

If you are convinced that luck plays an important role in your personal finance, how should you adjust your investment decisions? Active funds are expected to generate positive alpha. So, the investment outcome of such a fund depends on two elements — skill (and luck) of a portfolio manager and your skill (and luck) of choosing the right manager. This, perhaps, explains why an active fund that you pick does not consistently generate positive alpha (excess returns that a fund generates over its appropriate benchmark).

Passive funds depend solely on the performance of their benchmark index. The investment outcome of a such a fund depends on your luck that the market will perform well during the time horizon for your life goal — a factor that you are anyway exposed to because you cannot diversify market risk. Your investment success, therefore, depends on the market outcome (both active and passive funds) and the fund manager’s performance (only active funds).

But this does not in any way reduce the importance of your skill to balance current lifestyle and save for the future, and to choose investment products. Yet, for all your efforts, if the portfolio manager’s bad luck coincides with the time horizon for your life goal, you may be unable to achieve your goal. From the above, passive funds seem better for a goal-based portfolio, as you are exposed to only one element of luck (market outcome).

Conclusion

Luck plays an important role when an outcome is uncertain. Some attribute such outcome to randomness. The point is that luck (or randomness) plays a less important role in your investment in bank deposits compared to your equity investments. Why? Ignoring the small credit risk you are exposed to, the maturity value of a cumulative deposit or a recurring deposit is known. That is one of the reasons you must invest in bank deposits for your goal-based portfolios.

Even those who recognise the role of luck in their investment success are likely to offer varying explanations. For instance, luck can be explained using astrology, philosophy, or spirituality. Whatever your personal belief, remember this: the outcome of your personal investment decisions is dependent on luck and skill. So, acknowledge the role of (good) luck and moderate your self-attribution bias and hindsight bias. That could improve your financial well-being.

(The writer offers training programmes for individuals to manage their personal investments)