Luck Vs Skills

The market conditions are such that it is getting increasingly difficult to think and act rationally. If the crash in March 2020 was dramatic, the subsequent recovery since April 2020 was equally remarkable. If you are someone who had a well-defined process or rules, you would be in the happy camp participating in the sharp market recovery. Others would either be cribbing about valuations or a whole host of other aspects.

Call it the sour grapes syndrome.

Remember, the scope for making significant returns in the market stems from irrationality. If everything is normal, then where is the scope for making significant returns. And, to cope with irrationality, both on the way up and way down, we need a process to stick to. Else, you will just be shooting in the dark.

Let us dig deeper into the topic for this week. You must have heard of this debate about Skill Vs Luck. Every one of us believes that when we make money in markets, it is because of our skill, and the blame for the losing trades is either assigned to luck or to someone else other than you. This is normal human behavior and maybe lots of people do not even realize this.

In this context, I strongly recommend you read the book “The Success Equation” written by Michael J. Mauboussin. In this book, the author talks about the characteristics of activities whose outcome is luck-driven and skill-driven. It is a fascinating book and I request everyone to read it.

Here is a graphic based on the book which classifies various activities in the Skill-Luck continuum.

It is evident from the above graphic that investing is something where luck plays a significant role in determining the outcome. In any activity that is luck-driven, it is important that we use a process-oriented approach because the outcome is not predictable. We are essentially dealing with probabilities here.

Hope you guys now realize why we emphasize so much on sticking to a process or system. Let me explain this again with my personal experience. This is an anecdote that happened several years ago.

I did not have any system or framework and took trades based on watching the screen and doing some “analysis” which was again not documented or objectively defined. I would take a trade and the price on most occasions would go against me. I would feel totally stranded and stressed out as I am not sure what needs to be done now. This is because we did not have a plan or process or a trading system.

Out of fear I would exit the trade only to see the price move in the direction I anticipated earlier. I will reenter the trade thinking that the earlier decision to exit was faulty and I was spot on with my analysis. Am sure you know what happens next.

I take the trade again only to see the price go against me. I will randomly exit again, and this cycle would continue every day. In between, on lucky days, I would end up making money which would provide false reinforcement to my thought process indicating that I am good in this activity.

Without even realizing your mistake, you will rinse and repeat the same mistake and your capital would have eroded significantly. Did you realize that you did have a system and that system was about consistently making mistakes? You ended up doing the same set of mistakes and the outcome was losses. And because you consistently followed this system (faulty loss-making one), your losses accumulated over time.

If you do the opposite of this, imagine what would happen?

If you maintain a journal and review it, you will realize that the losing trades are always triggered by the same mistakes and emotions. If you do not document your trades (again trade journal is important) you cannot understand or appreciate what I am talking about.
Once I started adopting a process-oriented approach, the decision-making was stress-free and the focus shifted to sticking to the process and not on the outcome. It is essential to achieve this mindset of shifting the focus from the outcome to the process.
You must realize:

• That the outcome of the next trade that you take is random and not influenced by the outcome of the previous or recent trades.

• Even if you do everything right by following your system etc, there is no compulsion that the trade would be a winner

• The more the number of trades you take and if those trades are based on a process that has a probability of making profits (also known as expectancy), you will end up being a profitable trader.

If you understand and appreciate the above concepts, you will also realize that you do not need any magic indicator or ideal indicator settings or that secret indicator or the magic Fibonacci number to make profits. Our focus all along has been on trivial aspects.

Even a simple process of buying or selling on say a multi-column breakout with appropriate stop loss & trailing stop loss approach is good enough to make money.

But, ask yourself if you have the conviction and the ability to just stick to this simple approach? Why or why not? We will address this issue in the upcoming newsletters. Stay tuned !!