Better to be smart than lucky

Better to be smart than lucky

“I’d rather be lucky than be smart!” A lecturer in fund management for my Master of Science in Applied Finance course used to repeat this mantra in class. He used to say that some seats were luckier than others on the trading floor. And traders who occupied those seats usually did very well.

The idea that you needed luck to succeed seemed like a good excuse. The fairy tale-like life of Forrest Gump, depicted in the hit movie starring Tom Hanks in the 1990s, added gloss to the notion. Wouldn’t it be nice if we could stumble through life like Gump, and serendipitously encounter one positive event after another?

In one part of the movie, the slow-witted Gump disclosed later in his life that he had bought into a fruit company on the advice of his superior in the army, and that he didn’t “have to worry about money no more”. The “fruit company” of course was Apple.

Well, two decades on – the first decade as an observer and commentator on the markets, and the second as a practitioner – my view has flipped 180 degrees.

The reason? Luck is not repeatable.

In our life’s journey, there are numerous decisions we make along the way. Where we are at any point in our life is the cumulative outcome of our decisions before that. One may be lucky early on in life, perhaps like Forrest Gump having bought into Apple when the company was still young.

The reason Gump didn’t have to worry about money later in his life was that Apple had done stupendously well, coupled with the fact that he had held on to the stock. In an alternate universe, Apple could have turned out to be a dud. Or Gump could have, in an alternative story line, encountered someone who told him to sell his holdings and invest the proceeds in, say, a nickel trading company which turned out to be a scam.

So the older and wiser me will definitely opt for the ability to consistently make “smart” decisions – decisions that would put me in a good place to reap positive returns time and again, while at the same time minimise the impact of potential bad outcomes on my overall well-being.

How does one make smart decisions?

Mr Morgan Housel, author of The Psychology Of Money, said: “Bad decisions happen when there’s only one acceptable version of the future.”

Encapsulated in that statement are two important concepts in investing. One, the need to understand probability, and two, the need to diversify.

The reality is that there is no such thing as a “100 per cent sure thing”. Hence we need to assess the probability of different scenarios playing out when making decisions. Do you switch course, do you quit your job, do you plough all you have into a start-up? Those who can consistently best assess the probability of success will stand themselves in good stead over the long term.

Say, a friend has recommended a stock to you. How do you know if you should buy the stock, and if so, how much of your savings should you allocate to that stock?

To arrive at a decision, we should consider a range of possibilities. For example, the possibility that the stock does nothing for three years, or that it rises 30 per cent in six months, or it falls 50 per cent within the next two years.

How we assign a probability to each scenario and arrive at a probable scenario will depend on, among other things, our understanding of how the world works (for example, what drives stock market returns), being informed by historical data, and being rational and not having our judgments coloured by greed or fear.

To be systematic, we can write down the various possibilities and then assign a probability to each of them, listing our reasoning. This will force us to think through each possibility more carefully.

Sometimes we may not have the necessary knowledge. Make the effort to find out. Today, humanity’s cumulative wisdom is available at our fingertips. Curb the impulse to want to get rich quick and take shortcuts.

Most times, common sense is a requisite. When something is too good to be true, it probably is. Give it a miss. Protecting your downside, especially those irrecoverable ones, is more important than exposing yourself to the upside.

The importance of reducing impairment to capital can be shown with this example – two investors have the same starting capital of $10,000 and the same arithmetic average returns of 10 per cent a year. But the “Disregard risk” investor had more volatile returns – up 50 per cent a year and down 30 per cent the next, as opposed to up 30 per cent and down 10 per cent for the “Manage risk” investor.

Despite the lower return during the positive years, the “Manage risk” investor’s capital grew to $21,925 by the 10th year. In contrast, the “Disregard risk” investor is significantly worse off, with the initial capital having grown to just $12,763 by the end of the 10th year. The inability to reduce the impact of setbacks will eat into your wealth in a very real sense.

Of course we may want to buy hope by betting on long-shot events, like buying a lottery ticket. The rule is to spend only loose change on these.

As for high-probability events, some pundits say bet big on them. Being a cautious person, I wouldn’t bet my house on anything even if it is assessed to have a very high probability of positive outcome. Here is a story about a well-thought-out plan that went awry.

Lieutenant-Commander Victor Alonzo Prather Jr was involved in a US government programme to test prototype space suits. On May 4, 1961, he ascended in a balloon to 113,740 ft where the temperature was minus 29 deg C and the air pressure was extremely thin. The flight was a success and the full-pressure suit Prather wore passed with flying colours.

As he descended back to earth, he opened the face plate on his helmet when he was low enough to breathe on his own. He landed in the ocean as planned, but there was a mishap: Prather slipped from his craft while connecting himself to the rescue helicopter’s line, falling into the ocean.

The helicopter crew assumed that the flight suit was watertight, which it would have been if the face plate was still closed, and did not effect an immediate rescue. Prather drowned.

All contingencies the team could think of were rehearsed. But a mishap nobody thought of caused a catastrophe. Risks come from the known unknowns as well as unknown unknowns.

So I prefer to place many small bets on events with favourable odds. As Vincent Van Gogh put it: “Great things are done by a series of small things brought together.”

If we consistently put ourselves in situations where the odds favour us, and manage our risks such that we don’t suffer irrecoverable setbacks, then over repeated iterations, we will come out ahead. We may not be able to get filthy rich overnight. But our wins will compound over time.

Luck, in the winning-the-lottery sense, can’t be controlled. But we can create our everyday good luck and avoid catastrophic bad luck by being smart in understanding the odds and scaling our bets to protect our downside. The wiser me most certainly prefers the latter.

• Teh Hooi Ling is the author of ST Press’ Show Me The Money books. She now runs a no-management-fee Asia fund, Inclusif Value Fund (www.inclusif.com.sg).

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