The role of luck in investing

I'm a lucky guy. One of the more thrilling examples of my substantial good fortune occurred almost 10 years ago. I'd been watching the Global Financial Crisis unfold and started seeing opportunities in the stock market. Being a uni student with little capital, though, I had only one option: borrow money or risk missing out. So I decided to get a $15,000 personal loan.

This is how I got started in investing. What I did next still baffles me. I didn't take the $15,000 and buy undervalued blue-chips. I opened a CFD account with it instead. CFDs are a type of derivative contract that let you leverage your capital to gain or lose from share price movements without owning stocks directly. 

I took my borrowed money and then further leveraged it by around 7:1 to buy a basket of stocks I considered undervalued. 

That's the crazy part; here's the lucky part. By coincidence, I had opened the account just a couple of weeks after the S&P 500 index hit its lowest point. The stock market rose 40% nearly unimpeded after I bought my first CFDs. All the stocks I picked immediately went up. So I did what any other insane person would do - I used my newly minted equity to leverage myself even more. By the time I closed the account, I was leveraged at least 10:1.

That year set me up financially in a way I could never have anticipated. But here's the kicker: my selection process for choosing 'undervalued' stocks was that their share price charts followed a particular shape. I didn't even know what some of these companies did.

Losing on purpose

Hedge fund manager Michael Mauboussin has written a great book on how to separate skill and luck. In it, he presents a simple question to determine whether an activity requires luck to succeed: ask yourself whether you could lose on purpose. If it's difficult to intentionally lose, then luck probably plays a role in the outcome. If you can lose on purpose, then skill is involved.

My experience with CFDs should be proof enough that investing involves luck. I was lucky that the market skyrocketed when I had no idea what I was doing, and I was lucky to realise I was in over my head early enough to get out alive. I could just as easily have blown up the account and been forced to declare bankruptcy.

Still, many approach investing as solely a game of skill, particularly if they have a track record of doing well. Psychologists call this hindsight bias. When you're sailing into the wind, you can think of nothing else. We rarely fail to identify bad luck, whether in investing or some other sphere of life. But when the wind is at your back, it's quickly forgotten. It's easy to misattribute favourable tailwinds to skilled sailing. Human minds are just better at identifying obstacles than the subtle factors working in our favour. As American writer E.B. White once wrote: 'Luck is not something you can mention in the presence of self-made men.'

How to profit from luck

I'm not saying that investing is purely a matter of chance. Far from it. Many long-term performance records suggest it's possible to consistently beat the average using a combination of skill, insight, a sound investing philosophy, and hard work. However, neglecting the added influence of luck is likely to cause problems.   

First, it can lead you to act more riskily due to overconfidence - say, by concentrating your portfolio in just a few stocks or by using borrowed money. Most forms of leverage, especially CFDs and margin loans, have a tendency to crystalise your losses at exactly the wrong time, which removes one of the key advantages you have as an investor - a long-term horizon with the ability to weather short-term volatility.

Another reason to recognise luck is that it can widen your exposure to positive, rare events. One concept Nassim Taleb has raised is that of adding 'optionality' to your portfolio - seeking out assets or situations where there's an asymmetric upside with very limited downside. 

In horse racing, one of the most consistent trends is that 'long shots' - horses with an extremely remote chance of winning - tend to be undervalued. A horse may be paying 1,000:1 but actually have a 1-in-500 chance of winning. You won't win very often, but random things can happen - horses trip, jockeys fall, lightning strikes etc. - and when they do, the winnings on your long shot can more than make up for the minor losses you've incurred in the interim. 

Unlucky days are inevitable in investing, so a diverse set of high-quality stocks with limited downside should form the core of your portfolio. But, for investors with a high tolerance for risk, we also have a few Speculative Buy recommendations to add a dose of optionality. As Roman philosopher Seneca put it, 'Luck is a matter of preparation meeting opportunity.'