There is a difference between luck and skill and knowing when you are just lucky and when you are successful due to skill is of paramount importance as an investor.
For instance, let’s say you correctly called the flip of a coin five times in a row. What are the odds that you will correctly call the next flip?
Correctly calling five flips in a row might be considered a “hot streak” and lead you to believe that chances are high you can correctly call the next flip. Well, assuming it is a fair flip, there is, of course, only a 50/50 chance that you will be correct because flipping a coin is a game of known probability. The fact is the coin flip has no memory of your hot streak.
And, just like a coin flip, an investor who is on a “hot streak” may simply be lucky.
With millions of investors, odds are that some of them will make winning investments numerous times in a row.
If these winning investors were, in reality, just lucky, but they think they were actually skillful, then that is when the situation turns problematic. The lucky investor may start to think they are infallible and get stubborn when the market turns against them.
Eventually, when the lucky streak ends, it will likely mean serious losses for the investor.
The best antidote we know of to the danger of confusing luck and skill is to remain humble. When our investment strategy performs well, we are very thankful. When it doesn’t perform well, we accept this as part of the market cycle.
The investment business has an uncanny way of turning hubris into painful losses. We think humility is a safer route.
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