Wednesday, November 02, 2011

Eric Falkenstein on Chance, Effort, and Ability

Excellent post at Falkenblog on the critical linkage between Chance, Effort, and Ability-
"Success is the result of randomness, effort, and ability. If you omit one of these, you will be miserable. A lot of growing up is about finding what you like that you are good at, and usually you like things you are relatively good at. Then practice that skill until you become excellent at it. The rest you can't really worry about even though that too is important, especially in explaining things like why certain people are really rich, which is often being in the right place at the right time. This should make us content because it's all we can control."
Falkenstein's post was a rebuttal of the argument that most wealth attainment is the result of simple luck and randomness (versus skill, hard work, ingenuity). The key point is that success is most-often the result of a combination of elements: Chance, Effort, and Ability. On the other side of the spectrum, many institutional investors fail to understand this concept as well. Funds chase recent performance trends and managers promoting themselves with buzzwords like "portable alpha". More often than not, their returns are due to financial leverage or assuming risks their investors are not aware of. The investment process is the only thing that investors truly control, not the outcome!

Be extremely wary when someone promises a certain outcome with respect to markets or macro-events that are beyond their control. Hide your wallet, voting proxy, etc. and run the other way. An easy example might be a Presidential candidate promising the following:
     1) I will reduce the price of gasoline to $2/gallon, 
     2) I will reduce unemployment, 
     3) I will ensure that mothers do not have their homes foreclosed upon
     4) I will get government out of the way and let the free market work

This short list of contradictory promises/statements were all made by same politician (Rep. Bachmann). Take Promise #1: While $2 gasoline sounds like a great outcome, there is no substantive process for how it would be accomplished. Based on current technology, the most logical path to $2 gasoline would be a combination of crippling deflation, higher unemployment (lower demand for gas), or outright government intervention (price controls or banning automobiles). Each of these processes to achieve the desired outcome ($2/gallon gas) are clearly bad and have very negative side effects. This is why the process is so much more important than focusing strictly on outcomes! 

Even when you implement a "good process" does not guarantee a good outcome. Some of this is explained concisely in a chart created by Michael Mauboussin for his book "Think Twice",


The lesson to take away is:  implement a good process that you can consistently repeat and employ in both good and badtimes, along with not getting a big head over your success (it may be partly due to luck!) For investments, that means avoid being over-leveraged and concentrated in positions that you are not a control investor in.  This allows you to take advantage of future opportunities that do not exist and cannot be foreseen. In the words of Louis Pasteur, "Chance favors the prepared mind"...and portfolio.

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