The Role of Luck and Randomness

Along with millions of other Americans, our office held a small pool for the NCAA basketball tournament this past March.  We filled out our brackets and let the games play out.

Well, I won, despite spending less than 7 minutes constructing my bracket (possibly to the annoyance of some at the firm). I know a little about college basketball and understand the basics but didn’t follow this past season or the NCAA tournament at all.  So how did I win? It wasn’t a superhuman ability to filter and synthesize loads of information, nor am I being overly humble or allowing my introverted nature to prevent me from taking full credit for my accomplishment.

I actually shared my secret with the team once I officially received the interoffice trophy at our staff meeting following the tournament. I’ll tell you what I told them – it was luck. My winning was a random occurrence.

Luck and randomness are ever-present in our lives, and particularly in our investments.  Here are three important things to know about luck and randomness and how we can use this knowledge to make us better investors:

  1. Don’t confuse luck with skill

Winning the office pool one time wasn’t evidence of any special skill I have for lotteries or analyzing college basketball match-ups.  Likewise, just focusing on the results of any one investment clouds the issue of luck versus skill, particularly in the short term. Maybe you did a skillful job identifying something that the rest of the market couldn’t see, but there’s a good chance that the 150% gain on that high-flying stock you bought just a short time ago was due to luck. When one can repeatedly replicate that stock picking prowess over very long time periods then maybe it ventures into the realm of skill.

  1. Don’t try to control randomness

Certain things in this world are out of our control. No matter how much fans wanted to, they couldn’t will Virginia into coming back against UMBC and not blowing up everyone’s bracket.  When it comes to investments, our firm’s philosophy is that you can’t control the markets, and we don’t try to.  Luckily, one doesn’t need to in order to be successful.  We don’t jump in and out in anticipation of what the market may or may not do.  We rebalance as necessary which creates a disciplined way to buy low and sell high, taking emotion out of the equation.  As investors, we can focus on factors that are in our control – saving, spending, and prudent diversification of our investments.

  1. Don’t try to develop patterns from random events

When we have our office pool again next year, perhaps I should use the same selection methodology that I used this year (which I don’t even remember) because maybe there’s some pattern.  It likely won’t work since there’s no pattern, even though I may think there is.  For better or worse, the human brain is hardwired to look for and create patterns, even where they don’t exist. Our brains typically look for the easiest, most efficient way to do things.  And patterns, whether true or false, allow us to do that.

When it comes to investing, there’s also no shortage of people working on patterns based on what’s happened or what might happen. It’s a little like Mad Libs for investing:  “Oil will go [down or up], which means that the dollar will go [up or down], which means that we’re ripe for a [downturn or upturn] because that’s what happened last time, which means it’s time to rotate [into or out of] this [sector/country/asset class].”

If you’re a client of the firm, you know that we believe in holding a broadly diversified set of investments for the long term.  You’ve also probably seen the investment “quilt” chart that ranks the performance of various asset classes over the last 20 years.  We love this chart because it demonstrates that trying to discern next year’s winners and losers based on the rankings of previous years is a fool’s errand. There’s no pattern, yet there’s also no shortage of ideas on how to create a pattern that’s not there.

So, it’s nice that I won the office pool and with that, bragging rights for a year, so long as I remember how it was that I won.  It was luck – pure and simple.  And I can completely accept it.

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Swimming Superstar Katie Ledecky Decides To Go Pro – A conversation between financial planners

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Copyright: https://www.123rf.com/profile_torwai’>torwai / 123RF Stock Photo

 

Joe:  Well Allison, it looks like we’re back at it.  Katie Ledecky has finally decided to turn pro just as I recommended a year and a half ago.

Allison:  Yes, Joe, I saw the news release.  Are you saying that you were right all along?

Joe:  Well…If you recall, I suggested that she maximize her earning potential and take advantage of the many sponsorship opportunities that would be available to her once she became a professional and renounced her amateur status.  I was concerned that she might get injured and not be able to maximize her earning potential.  I was focused on the freedom and flexibility that her multi-million-dollar sponsorship deals would provide her – I mean, she won’t be a professional swimmer forever.

Allison:  But Joe, there’s more to the story than that.  Katie Ledecky is only giving up competing for Stanford in NCAA competitions.  She’s going to continue to attend classes and pursue her degree.  And she’ll still be able to do some training with her teammates.  Turning pro will let her fine tune her own training and schedule so she can focus on the 2020 Olympics.

Joe:  That all makes sense.  I guess it’s not worth thinking about the money that she could have earned and all the good she could have done with that.

Allison:  She said at her press conference that she didn’t have any regrets about waiting to turn pro.  She’s still only 21 and has plenty of time to make money from her sponsorships.  What you’re forgetting is that maybe it was never entirely about the money for her.

Joe:  You said “entirely.”

Allison:  I know, and here’s what I mean: she wanted to be part of a team and attend a great university.  And swimming collegiately at Stanford allowed her to do that. I think she just wanted to be a normal college student.

Joe:  You said “normal” – she’s probably swam more miles in the pool in the last year than I put on my car.  She’s a superhuman elite athlete! I just wanted her to take full advantage of her abilities.

Allison:  Maybe that’s not what she wanted.  The endorsement money might be great, but I’m not worried about her having waited a few years to start collecting it.  By the way, she’s also got a 4.0 GPA, so if swimming doesn’t work out, she’ll probably be ok.

Joe:  Like I said, not normal…

So, I guess it isn’t always about maximizing wealth.

Allison:  Not always.

So, what have you learned from all this and how might it help you be a better financial planner?

Joe:  I’ve learned not to jump to conclusions.  I’ve learned to listen, to present options and to go over their pros and cons.

Allison:  And you’ve learned that we don’t always have to do what the numbers say to do.

Joe:  Right.  And that most financial planning matters are rarely an “all-or-nothing” circumstance.  That there’s room for compromises and a combination of different strategies.

Allison:  Well thanks, Joe.  I guess that wraps things up.  I’m looking forward to our next chat and the lessons we’ll learn to help us become better planners for our clients.

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Your Portfolio and the Saguaro Cactus

The Saguaro cactus (pronounced Sah-wa-ro) grows exclusively in the Sonoran Desert, which extends into areas of California, Arizona and Northern Mexico. It’s an incredible plant with amazing characteristics and a lifespan measured in centuries.

Because of its massive size and unique internal and external structure, it serves as a home and water source for multiple other species in its ecosystem. But this fascinating plant also offers some powerful “investment portfolio” lessons.

  1. The Saguaro is incredibly slow growing. After 10 years, it’s typically only about 1 ½ inches tall – that’s inches, not feet! But as the decades roll by, it reaches a full height of 40 to 60 feet and can weigh 3,200 to 4,800 pounds. Saguaros can live for 150 to 200 years.

Just like the Saguaro, it takes time to grow an investment portfolio. A lot of time. The power of compounding is always present but really starts to kick in after about a decade. We can’t get frustrated and try to accelerate this process by taking unnecessary financial risks.

  1. The Saguaro’s life cycle is quite volatile. Neighboring animals are constantly drilling into the cactus to extract water. Along with variations in the local climate and particularly rainfall, this means that the Saguaro’s water reserves can vary significantly. They can shrink or swell in size by 20-25% over the course of a year.

Investment portfolios can undergo similar volatility. That’s the “environment” of the investment trade-off: the potential for return is paired with the potential for volatility. And like the Saguaro we need to persevere. The Saguaro doesn’t shrivel up and die but rolls with the punches and continues its progression of growth.

  1. The Saguaro has a very particular blooming cycle. Once per year, in the late spring, its white flowers bloom at night and last through the next midday, providing only a small pollination window. The flowers secrete a sweet nectar that attracts birds, bats and other insects who pollinate the blooms, leading to Saguaro cactus fruit in the fall. A single fruit can produce thousands of seeds to help grow the next Saguaro.

Like the Saguaro’s small pollination window, we don’t know in advance when investment gains will happen. There’s no shortage of theories about how to try to time the market, but historically the best approach to avoid missing out on gains has been simply to stay invested and let the power of the market work for you. Doing so allows folks to not only reap the fruit of ongoing interest and dividends, but also to grow portfolios through capital appreciation.

  1. Saguaros are considered to be a foundational or keystone species. They provide much to their local ecosystem – nesting, homes, and water to numerous animals including owls, woodpeckers, snakes, mice, bats, insects, and even bobcats.

Portfolios are also foundational. They serve a greater purpose than their own numerical value. Ideally, we’ve given them plenty of time to grow and stayed with them through thick and thin.  In return, they will fund our personal lifestyles, goals and dreams as well as potentially those of our family or favorite charities.

Sources:

https://www.desertmuseum.org/kids/oz/long-fact-sheets/Saguaro%20Cactus.php

https://www.tripsavvy.com/saguaro-cactus-4051681

https://www.sciencefriday.com/articles/11-things-you-didnt-know-about-saguaro-cacti/

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Investment Lessons from the University of Maryland Baltimore County “Retrievers”

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The most dramatic game of the 2018 NCAA Men’s Basketball tournament thus far was the victory of 16th seeded University of Maryland Baltimore County (UMBC) over the (overall) number one seeded University of Virginia (UVA).  For those not familiar, the NCAA tournament is a 64-team tournament, split into 4 regions. Within each region, teams are initially seeded or ranked from 1 to 16 – the higher the seeding, the better the team.

Based on probability, UMBC was not supposed to win the game and UVA was not supposed to lose the game.  There have been 135 previous matchups between #1 and #16 seeds over the last 30+ years and the #16 seed has never won.  Ever.  Because of this fact, 99.4% of all NCAA brackets had picked UVA to win the game. But that’s not what happened.  It was the thrill of victory for Baltimore and the agony of defeat for Charlottesville.

I don’t follow college basketball as much as I used to.  I’m a casual fan but this game got me thinking about statistics, and biases, and investment philosophy.  The game was a fantastic spectacle full of investment lessons for us all, starting with…

#1  The rare circumstance can happen, but it’s rare for a reason.

The first lesson is that we don’t want to take on unnecessary risk by chasing stocks that we heard someone talk about on the radio or TV.  We ought not try to build wealth by hitting “home-runs.” Could we possibly identify the next Amazon, Facebook, Google, or Apple before their share prices exploded? Maybe, but the odds are certainly not in our favor.  It may seem obvious in retrospect later, but it wasn’t obvious beforehand.  Better to stick with the steady and prudent approach to accumulating wealth that has stood the test of time.

I saw an online image of a ticket from a sports book that shows an $800 bet on UMBC that resulted in a payout of $16,800.  It’s so enticing – all I had to do was bet $800 and I would have made back 20 times that amount.  Well you would have, on this bet.  If you had bet the same $800 on all the previous #1 vs. #16 seed games, you would have lost $108,000.  Suddenly the $16,800 payoff doesn’t seem that great.

But what if you were a student or a graduate or a former player for UMBC? Surely you have an inside track or some special knowledge.  Well, you think that because you’re suffering from…

#2  Hometown and other biases

I spent 7 years living in Charlottesville, and I know a fair amount of people connected with UVA.  Did that color my thoughts on them possibly winning this particular basketball game?  I can’t say for certain, but it likely did.  I probably thought consciously or sub-consciously that they would win because they were the better team, they were supposed to win and plus, I lived a few miles from the university.  And it’s an excellent university – but I’m biased.

As mentioned earlier, only 0.6% of all brackets picked UMBC to beat UVA.  My guess is that most of those 0.6% live within a 10-mile radius of the UMBC campus or had some affiliation with the university.  I don’t think they had any special knowledge, I think they were just being fans.

We often become fans of our investments.  We might own a lot of our employer’s stock because we earn our paycheck there, we understand how things work (at least we think we do), and we’re “fans” of the company.  We might own a disproportionate amount of stock in a company because we like their snazzy products or their hip services.  And we incorrectly think that this company whose stock we own will always be good, which leads us to our next investment lesson…

#3  Great stocks or great companies don’t always remain so.

UVA was not supposed to lose this game.  They were the #1 seed.  They were favored by 20+ points.  They were a lock.  But they lost the game.  And just like the favorites can lose, great companies can fall and struggle and be in the news for all the wrong reasons.  Technology is changing at breakneck speed, there’s constant innovation in so many different fields of industry, and there’s an awful lot about companies that we don’t know and can’t predict – even if we work there or even if we love their products.

The UMBC-UVA basketball game was one for the ages.  If the statistics hold, there won’t be a win by a #16 seed for another 30 years.  While we patiently wait for the next “greatest upset of all time”, we can manage our investments in such a way that we don’t have to swing for the fences or let our biases get the best of us.  Ideally, we want our investments to own all the teams in the tournament because what we expect to happen might not actually happen.

 

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