Lucky boots and randomness

Lucky boots and randomness

Image from Jugbo on VisualHunt.com

In 1997, an Austrian racing driver called Alex Wurz achieved every car racer’s dream of securing a seat in Formula 1.  His first team was Benetton, where he substituted for his countryman Gerhard Berger in Montreal when the latter was ill.  Having made the podium in only his third race before Berger returned, the team recognised his talent with a race seat for the following year.  However, a succession of less impressive cars meant that his three seasons there delivered disappointing results and in 2001 he moved to McLaren as test driver.

One of Wurz’s peculiarities of his career to date was that he always wore one red and one blue racing boot, on the basis that it gave him luck.  At the time, McLaren was still run by the obsessive Ron Dennis (the team’s first activity on arriving at a race circuit was to repaint the garage floor).  Unsurprisingly, Dennis was unimpressed by any notion that the colour of his boots would affect his results and so from then on, it was matching boots for Alex.

Attributing their success to lucky charms or rituals is not uncommon in the world of sport.  Similarly, there are many investors who follow such superstitions.  When they do well, they see their success as evidence of their superior skill.  Yet when they do badly, they attribute it to external factors outside their control or to bad luck.  What they tend to disregard is the possibility that their results, in both instances, are just random.  Economists have a phrase for this: ‘self-attribution bias’.  However, it is only one of many behavioural biases which affect investors.

Others include the tendency to believe that we are smarter than everyone else (overconfidence), assuming that recent patterns will continue (extrapolation) and investing in things that we think we know best due to the illusion of control (familiarity).  We observed the latter in a client with whom we started working in 2006. 

He had always worked with the banking sector and therefore was satisfied that he knew enough about it to be successful concentrating his investments there.  He was therefore wary of our more diversified approach as he felt that it would not deliver the returns he wanted.  Not long after he invested in such a diversified portfolio, the global financial crisis hit.  Like most other investors, both amateur and professional, he failed to see it coming despite his apparent insights.  He later commented that had he not been advised as he was, he would have continued to invest in what he knew and been hammered when bank share prices plummeted.  It is worth pointing out that we had no insight into the storm to come either so it was not our own predictive ability which protected him from its worst ravages.

Behavioural economists have also identified biases to interpret, after the fact, sharp market movements as having been obvious (hindsight) and a tendency, after a bad investment experience, to become over conservative (regret).

These biases are not necessarily always bad – successful sportspeople and entrepreneurs are often driven by their ego and therefore their overconfidence keeps them going when circumstances may be adverse.  Gamblers are also particularly prone to overconfidence, even though the odds always favour the house and not the gambler.  For an investor, however, overconfidence can be extremely damaging.  While the gambler is in competition with the house (one wins, the other loses), for the investor the market is neutral.

Treating it as a competitor to be beaten causes us to miss out on the returns of markets in good times and to sell out of them in bad, turning paper losses into real ones.  It also leads us to overconcentrate on a few sectors or companies which expose us to an uncompensated risk and to incur unnecessary trading costs and taxes.  Yet it does not have to be this way.  We need not allow our biases to influence our investment decision-making processes.  It just requires the application of traits which are within our power, those of self-discipline and maintaining diversification.

The future will always be uncertain.  Stockmarkets will therefore always fluctuate in value.  However, the fluctuations are the outcome of it processing news very rapidly and as news is continuous and can be interpreted by each investor differently, they reflect how efficient it is at combining all those expectations into prices.  The odds, unlike for the gambler, are with the investor who allows the market to do its thing and doesn’t try to outguess it.

Success at investing, therefore, comes from recognising our susceptibility to biases and leaving them at the door.  Our biggest competitor in achieving that is likely to be ourselves.

And Herr Wurz of the mismatched footwear?  In all his races up to 2000 wearing differently coloured boots, he stood on the podium in 14% of his races.  After switching to matching ones, he did so 30% of the time, including two wins of the Le Mans 24-hour.  Maybe there were other factors involved then….