In most endeavors, there is a direct correlation between efforts and results. If you are smart and do the hard work, then you will produce positive results.
The stock market doesn't quite work that way. You can do endless research, study charts, and know every nuance of the fundamentals but still have a negative result. Traders and investors are ultimately trying to predict the future, and when someone tries to do that, then luck will be a major factor in determining the outcome.
Most market players underestimate the role of luck in their trading, and that is especially so when it is good luck. We are much more willing to attribute good results to skill and bad results to luck. But luck is an equal opportunity employer, and it cuts both ways.
It is a mistake to assume that good results are an indication that you have made good decisions. It is also a mistake to believe that bad results mean that you made poor decisions or done something wrong. The quality of your decision-making is not necessarily reflected in your results. The best traders in the world will often make a great decision but still have poor results.
A good analogy can be found in poker. In poker, you can execute perfect strategy and still end up a loser due to the way the cards may fall. You can also play a hand like a complete idiot and still win if Lady Luck is on your side. It is just the nature of any enterprise that deals with an uncertain future.
Although luck is an essential element of trading, most traders do not spend much time thinking about it, and they don't effectively incorporate it into their trading. Luck, both good and bad, is inevitable, and if you fail to appreciate that fact, your decision making will be suboptimal, and you will never grow and prosper as a trader.
The main problem when we have good luck is that it can lead to overconfidence and drive us to think that we can replicate a great outcome through sheer willpower. It is very easy to ignore the role of luck in a trade when we have spent countless hours contemplating it and thinking about it.
Overconfidence tends to produce bigger losses when the inevitable bad luck strikes again. We have been fooled into thinking we can always control the outcome when the reality is that luck is always lurking.
Picture two traders many years ago that are looking for a good stock to buy and hold. One buys Apple (AAPL) , and the other buy Enron. At the time, they both did extensive research, studied everything that was available, and felt confident that they made the right decision. One made a fortune while the other saw their stock go to zero. Was one of these investors more skillful than the other? To what degree was the outcome a function of just plain dumb luck?
That is a trick question because it ignores the power we have to manage a trade as it develops. That is how you deal with luck. You must recognize and find a way to manage the luck that occurs within the investing process.
How Do You Deal With Luck?
1. Don't underestimate the prevalence of luck. Every time that you enter a trade or investment, it is important to consider what can go right and what can go wrong but also it is important to understand that something completely unexpected may occur. There is always risk out there, and there is no way to eliminate it. It is going to hit you on a regular basis.
2. Make sure you have strategies that can handle a run of bad luck. One of the main reasons that it is important to use various forms of diversification is to make sure that a run of bad luck doesn't wipe you out. Your own defense against an ugly surprise is to not hold disproportionally large positions. That also means you won't benefit as much when good luck hits, so it is a constant battle to find the right balance.
Money management is essentially luck management. The idea is to find a methodology that limits the damage of bad luck while compounding the benefit of good luck. It requires constant vigilance, hard work, and good strategies and tactics.
3. Focus on the elements of trading that have the most real impact on results. In most cases, that will be money management rather than some big, bold prediction about the future. The only way you can improve as a trader is to separate out the luck component of trading and focus on the elements of your thinking that will have the most real impact on the results, such as timing, stop levels, news events, and so on. If you focus solely on results and don't dig in and dissect how luck played a part in each trade, then you won't really understand the quality of your trading process.
In addition to carefully analyzing the role of luck in your own trading, another way to improve your results is to study the trades of others. Unfortunately, traders have a tendency to brag, and they don't give us a true picture of what they are really doing. It is not like a poker table where information about decisions that others have made it easy to see. When you hear stories about a good or bad trade, evaluate how much of the outcome was due to skill or insight and how much was due to just a lucky confluence of events. That is the process that will help you improve your result.
Luck -- both good and bad -- is your constant companion in trading. The more you embrace it and understand it, the better your chances of producing superior returns.
(Apple is a holding in Jim Cramer's Action Alerts PLUS member club. Want to be alerted before Jim Cramer buys or sells AAPL? Learn more now.)
