I left you, at the end of yesterday’s post, with some strong evidence that luck plays a big part in your trading results. Now for the good news: you are not powerless against luck.
People say many different things about luck, like “luck is what happens when opportunity meets preparation.” Well, there’s certainly some truth to that (and value, from a motivational perspective), but that is not exactly how we are using the word here. Luck, in this case, means random variation that you cannot control. Luck can be good or bad, but it is, by definition, unpredictable and uncontrollable. ((Efforts to control luck tend to veer into superstition, and I suppose it’s worth giving a nod to all the shamans of the world (and all the floor traders who superstitiously wore the same necktie for 30 years even after it fell into tattered shreds) and admit there might be something we don’t know. However, that’s really not our focus here. We can manage the impact luck has on our results, even if we cannot directly influence luck.)) Even if we can’t control it, there are some things we can do to better understand and to manage the impact it has on our trading results:
- You absolutely must have an edge. In the short run, you can get lucky and make money doing something that has no edge, but expected value will catch up with you. Don’t gloss over this point, because it might just be the single most important thing we can say about trading–you have to have an edge. (Also, as Jack Schwager says, if you don’t know what your edge is, you don’t have one.)
- You must be consistent. You must trade with discipline. Nearly everyone who writes anything about trading says these things, but the why is important: you must be consistent because the market is so random. You cannot change your approach based on short-term results because those short term results are confounded by the level of noise in the market. In other words, you can lose doing the right thing and make money doing the wrong thing. Too many traders make adjustments based on evaluating a handful of trades, and this is likely a serious (fatal) error. See point 1: have an edge, and, now, apply that edge with consistent discipline. Markets are random; you don’t have to be.
- Luck matters. There’s no denying that, but so does skill and so does edge. In fact, the more skillful you are as a trader, paradoxically, the more luck matters. (See Mauboussin book and video link near the end of this post.) You can be successful without luck, but the wildly successful traders (who are outliers) always have some significant component of luck. If the overall level of investment skill in the market is rising (far from a certain conclusion, in my opinion), then performance will converge and luck will play a bigger part for the top performers.
- If you understand the part luck plays in your results, you will realize that emotional reactions to your results are largely inappropriate. Yes, that sentence sounds like something a Vulcan (from Star Trek) would say, but it’s true. Too many traders ride the emotional roller coaster from euphoria to depression based on their short term results, and this really doesn’t make sense because you’re letting luck (random fluctuation) jerk your emotions around. (It is worth considering, though, that this works for some traders and may actually help their performance.)
Some people take this message, that luck, good or bad, is important and unavoidable, as bad news. It isn’t bad news at all. You are still responsible for developing your trading method and your skill as an investor. Without those things, you won’t make it. It’s very unlikely that you can do everything right over a long period of time and not perform adequately well. However, many people focus on outlier-type stories as their motivation for getting into the market: people who took a few thousand dollars to hundreds of millions, people who make incredible returns in a short period of time, etc. If you understand the part luck plays then you will understand that this cannot be a goal or motivation for getting into the markets, because those outlier returns were people who got lucky. Maybe you will too (by definition, you probably won’t), but your focus must be on building a disciplined, core trading methodology rather than trying to get lucky.
If this topic interests you, let me recommend a fantastic book. In The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing, Michael Mauboussin takes a deep look at measuring the contribution of skill and luck to success, and draws some fascinating parallels from sports. This is one of the most important books I’ve read in a long time, and I’d highly recommend it to anyone who manages money or trades in the markets. In addition, take a look at the video below. It’s an hour, but it’s an hour well spent with a speaker who has a real talent for making profound topics easily accessible.