With World Cup fever, we are all glued to the television. We ask all the important questions, like: Who will win? Who is poised to win the golden boot? Is Ronaldo now better than Messi? Could Harry Kane be the best number nine in the world right now?
Dan Kemp, Chief Investment Officer at Morningstar Investment Management- EMEA, writes about what we can learn from the World Cup.
What is the role of luck in winning the World Cup? How much of the German 2014 victory was luck and how much was skill?
As humans, it’s fair to say we like to attribute success to an input. Hard work, intelligence, teamwork, strategy, skill, and so on. But rarely, do we admit the role that luck plays on an outcome. This is true in sport, investing and life. Very rarely will you hear someone say that Germany got lucky in 2014. Similarly, we’ll rarely say that a property mogul got lucky during a major property boom.
A rational decision-maker should acknowledge the role luck plays. That’s not to say we should become sceptics of successful participants, but instead appreciate the range of outcomes we may be exposed to.
In many ways, it’s about understanding what is knowable versus unknowable. For instance, we can see a clear link between the work ethic of Cristiano Ronaldo and his success, so it might seem reasonable to give him the ball at the most pressurised moments. However, we should also keep in mind what behavioural scientists refer to as the “hot-hand fallacy”, which is used to explain the dangers of extrapolating luck.
Take the example of Ronaldo and a free kick on the edge of the box. His long-term record shows that he will score in around 4.2% of all free kicks, a lot higher than the average player but hardly a guarantee. Yet, if he scores in the World Cup, as he did against Spain, many think this outcome was deserved and will place a heightened confidence in his next free kick.
What is more important in winning the big prize, superior skill, a mental edge or good old-fashioned luck?
It is a strange concept that the team with the best players don’t always win the World Cup. Star individuals regularly fail to make a star team and we all have our opinion on why this is the case. For most, the answer boils down to a few key variables like passion, teamwork and structure. So, while a team of weak players can only get you so far, understanding your edge is extremely underrated.
In many respects, this has as many parallels to investing as it does to winning the World Cup. Bill Miller from Legg Mason was often famed for saying an investor has three exclusive edges they can obtain: “an informational edge, an analytical edge and a behavioural edge”. We would add an “organisational edge” to this list, but the lesson is conceptually the same.
A fine example would be the 7-1 capitulation of Brazil against Germany in the semi-final of 2014. If you analyse the Brazilian squad, their skill level was hardly inferior to that of Germany, yet they lost convincingly. Was this due to mental weakness? Did they adopt a structure that allowed ego? Or was it a random outcome at the outer bounds of the probability curve? If you want to succeed as an investor you will also need to embrace uncertainty and vulnerability. You can do this by ensuring you have the necessary skill but also the mental discipline and structures to sustain your edge.
So, what can we learn from this?
As a portfolio management team, we need to understand ourselves first, including an honest appraisal of what our true edge/s might be.
When constructing a portfolio, we might also want to give careful thought to how each asset class contributes to the portfolio.
Finally, we want to avoid having too much confidence in our star strikers or past successes – for example, expecting big things from a few cyclical exposures that have been pegged to an expansionary phase, instead ensuring we think holistically.
Why do we embrace our own predictions so confidently?
Confidence and prediction often go hand-in-hand. We are all too eager to seek out certainty, but in football as well as investing, it is extremely rare to predict any outcome with a 100% probability.
This is no more evident than in the office tradition of a sweepstake. As we join our colleagues and each pull a country name out of the hat, it inevitably sparks sharp debate on whether we have a chance at success. “Ah, I got England”, one will say… “I’m a great chance of winning this year”. Everyone will suss out their respective competition, casting judgement on the likelihood of proceeding to the Round of 16 and so on. If they feel lucky enough, like the England ticket holder, they can become exposed to an endowment effect as they dream about that magical feeling from winning.
This form of mind mapping is not unusual – we all do it, yet it is rather bizarre. If we have one lesson to share from the world of investing, it must be that our short-term predictive abilities are incredibly poor. The modern world is stuffed with ways to spot the next big thing, but ultimately, too many people get it wrong for it to be right.
Furthermore, when investing, we are often required to apply further levels of thought: How much fear or greed is priced in? What are the likely range of outcomes? How should I size my conviction given the probabilities? The list goes on.
So, while we all daydream of our future-selves holding the office trophy with pride, we also need a blank and stern reality check that our predictions are futile. Rather than trying to source the star performer, we should therefore focus on the things we can control or that we know with certainty will add to returns.
Examples include:
- Controlling our behavioural biases
- Understanding portfolio risk drivers
- Lowering our costs – embracing the research showing lower fees enhance returns
The original post appeared on Morningstar.co.uk
