I was recently reading Nate Silver’s excellent book called: The Signal and the Noise. The book deals with a number of really important issues that investors have to deal with including probabilistic thinking; and disaggregating skill and luck (which Silver refers to as the signal and the noise).
This latter issue is really important to consider when we evaluate investments after the fact. (And we recommend all investors do this to extract as many learnings as possible). It’s not just the investments that turn out poorly; we would also recommend evaluating the investments that turn out favourably.
In our view (and the view of Silver’s), it’s not the result that matters. The challenge is separating process from luck. At various points in time, investors will experience instances of good luck and bad luck. And this is out of the control of the investor. Process, on the other hand, is entirely in the control of the investor. And strong, sustainable returns over the medium term will only be possible with a thoughtful and disciplined process.
Here’s how Silver puts it:
“In the United States, we live in a very results-oriented society. If someone is rich or famous or beautiful, we tend to think they deserve to be those things…
As an empirical matter, however, success is determined by some combination of hard work, natural talent, and a person’s opportunities and environment – in other words, some combination of noise and signal…
When it comes to prediction, we’re really results-oriented. The investor who calls the stock market bottom is heralded as a genius, even if he had some buggy statistical model that just happened to get it right…”
The reverse of this final point is also often true. That is, should an investment go poorly, humans are quick to blame the investor as lacking skill. Yet it may well be the case that it was simply bad luck – well out of the control of the investor.
“… Sometimes the only solution when the data is very noisy – is to focus more on process than on results… (In a sense, we’ll be predicting how good his predictions will be).”
This is true for investing as well. Upon reviewing the success or failure of an investment, one should review the process, not the outcome. We summarize the decision tree in the chart below.As illustrated above, investments that turn out both favourably and unfavourably – but for the wrong reasons – require adjustment to the process and/or its implementation. Separating skill from luck is important when we evaluate investment ideas after the fact. Similarly, these are concepts that are important for clients to keep in mind when evaluating the performance of their investment managers.