Wrap your arms around the uncertainty.

Life is full of decisions.  Research shows that we make 35,000 a day.  Some of these are subconscious, impulsive and inconsequential.  But some are not.  We make big decisions along the way that dictate the path that our life takes. 

If I think through my adulthood, here are my big decisions that changed my life; deciding to take a gap year and reapply to university (this led to me going to Oxford instead of Edinburgh), picking Rathbones as my first place to work (this led to me meeting Al, my husband), moving with him to Cayman (this changed everything), deciding to marry him (my defining decision), buying our home (a big financial decision), having three children (my greatest blessing), setting up my own firm (so far so good).

When we look back at our life and the decisions that we have made, how do we judge the quality of those decisions?  As normal human beings, we tend to look at the outcome of the decision.  Was the outcome good or bad?  Good outcome = good decision.  Bad outcome = bad decision.  My big decisions so far have turned out well.  My conclusion?  I made good decisions.

But this is not always the case of course.  When you throw the randomness of the world and chance into the equation you find that good decisions will sometimes lead to bad outcomes and bad decisions will sometimes lead to good outcomes. 


Let’s take an example of a surgeon who is deciding whether or not to perform a risky operation that he knows has a certain probability of success.  Studies* have shown that after finding out whether the patient lives or dies, people judge the quality of the surgeon’s decision differently.  This is called outcome bias.  This tendency to evaluate decisions on the quality of the outcome rather than on the quality of the decision-making process itself can be dangerous, particularly when it comes to anything where there is a high degree of randomness, chance or luck (think: investing and financial markets).

This matrix shows what can happen when we combine our process with outcome:

Source: Winning Decisions: Getting it Right the First Time by J. Edward Russo and Paul J. H. Schoemaker

Source: Winning Decisions: Getting it Right the First Time by J. Edward Russo and Paul J. H. Schoemaker

The two boxes on the left of this matrix are most interesting to me because this is the line between skill and luck. It’s not black and white.  There is a continuum of luck and skill and the two can be very hard to distinguish from one another.  If you land in the bottom left box (“dumb luck”) too often you can end up overconfident, and that has its own set of problems.

Michael Mauboussin, Director of Research at BlueMountain Capital Management, is famous for his work on skill on luck.  He shows the continuum for a range of activities below:

luck v skill.jpg

How do you know whether something is more about luck or skill? Mauboussin has an interesting way to test whether there is any skill in an activity, and that is to ask whether you can lose on purpose.  This methodology puts roulette at one end – pure luck, and chess at the other – pure skill.  A skilled chess player could easily lose on purpose but you can’t easily lose at roulette on purpose.

What about investing?  You might be surprised to see how far over it appears on the luck end of the spectrum.  It’s very hard to put together a portfolio that does better than the benchmark, but it’s also really hard to put together a portfolio that does much worse than the benchmark. There is some skill involved, certainly over the long-term, but the problem is that its close to impossible to distinguish money earned by luck from money earned by skill.  This makes evaluating managers very hard. We have seen this time after time in the hedge fund world. A new manager launches a fund and has an outstanding first year. Money piles in. But the performance tapers off. Why? The first year was almost certainly due to luck. And unfortunately, this isn’t just a problem for professional investors, many retail investors find themselves in the bottom left hand corner of the matrix but they have no idea that they are there

This is how it goes.  You start picking stocks during a time when the markets are going up.  You do a bit of trading, and start making money.  Wow!  I am a genius you tell yourself.  This is easy.  Very quickly you become overconfident and with it you over-trade (research shows the two things go together).  At some point, hopefully, you realise that you don’t really know what you are doing, you have no formal investment process, you are purely speculating and it’s time to stop.  Unfortunately many never come to that realisation. 

Herein lies the difference between a long-term investor and a speculator.  A speculator really only cares about the outcome.  A long-term investor cares about process.  A long-term investor has a set of rules that they apply to the investment decisions that they make.  A speculator is shooting from the hip, trusting gut instinct and intuition.

I started Wharton 55 years ago last month. And the first thing I remember learning there is that you can’t tell the quality of a decision from the outcome. And that pervades my thinking. We understand that we’re going to make decisions that aren’t going to work, and the people we work with are going to make decisions that aren’t going to work, especially in the short run. They may work in the long run, but in the short run, a good decision that didn’t work can look an awful lot like a bad decision.
— Howard Marks, OakTree Capital

Accepting the randomness in the world in general, acknowledging the role of luck in our life, and focusing on the process we go through to make a decision is a powerful mindset to employ. Annie Duke, world famous poker player and author, is an expert on decision-making and luck. When asked the question, ‘how should we deal with the fact that there is so much luck involved in decisions?’, she replied:

Wrap your arms around the uncertainty. Accept it. Know that the way things turn out has a lot of luck involved so don’t be so hard on yourself when things go badly and don’t be so proud of yourself when they go well. Focus on process instead.



*No harm, no foul: The outcome bias in ethical judgments, Harvard Business School

Georgina Loxton