Never Confuse Luck With Smart Investing

(Bloomberg Opinion) -- What can we learn from the case of someone who turned $100,000 in short-dated call options into a $2.5 million profit?

As detailed in MarketWatch earlier this month, trader Steve Oliverez was pretty sure the Republican tax overhaul was going to be approved by Congress. Working with a data set of one -- the 1987 tax overhaul -- he correctly surmised that passage would be bullish for stocks.

His gamble paid off. Oliverez took his winnings, bought a new house with cash and took the rest of the year off to celebrate, traveling throughout the U.S., Southeast Asia and Japan. Who wouldn’t want to buy a new home and travel the world for a year? One trade, a huge return -- time to open that options-trading account and get in on the winnings.

No. Don't.

Investors need to beware of how highlighting one person's one winning trade is an invitation to trouble -- and losing money. Focusing on a single outcome  versus a repeatable process raises more questions than it answers, including:

-- Are these trade results statistically significant?

-- Was this trade the result of luck or skill?

-- What is the long-term track record of this approach?

-- Is it a repeatable strategy?

Poker champion Annie Duke notes that professional card players call the focus on what just occurred “resulting.” In her book “Thinking in Bets: Making Smarter Decisions When You Don't Have All the Facts,” she explains the problem with this approach. “Resulting” assumes “the quality of the outcome tells you about the quality of the decision-making.” It doesn’t.

Looking at a single big winning trade suffers from this same error.

Resulting looks to me like a combination of several other behavioral problems: Availability bias (thinking that what comes easily to mind is representative) in what we read in online media; a degree of hindsight bias in the after-the-fact explanation as to why this was a good trade; some outcome-over-process focus as well. But perhaps the most important aspect of this is the survivorship bias: How many trades that were losers were not included in the discussion?

Some years ago, I pointed out how various lost-and-found trades are a classic example of survivorship bias. Two favorites are the lost EMC stock certificate and forgotten bitcoin purchase. In each case, the record of an investment was somehow misplaced. Many years later, when they were found, these positions had enormous gains.

Why survivorship bias? These big trade winners generate headlines, but the day-to-day run-of-the-mill wins and losses do not. Thus, you are more likely to learn about are the outsized gainers, with none of the offsetting losses provided for context. Let's cite a few headlines that you didn't see (because I made them up) to make the point:

-- Man Finds Worthless Lehman Brothers Stock in Attic

-- Woman Inherits 10 Million GM Shares Just Before Bankruptcy Filing

-- Misplaced AIG Shares Are Almost Worthless

-- Penny Stocks Found Under Mattress Lost All Value

OK, so these aren't real headlines, but they make the point. Yet, they reflect an important aspect of financial markets, or the fuller story about the vast majority of speculative trades.  They are not newsworthy, and so a selection bias in what makes news means you never saw them. Some of the imagined events are no doubt true, but there is no reason that you would ever know about them.

Mind you, there is nothing wrong with speculating if done wisely and with eyes open. Take a small portion of your assets -- no more than 5 percent of your liquid net worth -- and dump them into a separate account.   Label it “speculative fund” and do whatever you want with that capital: become an angel investor, buy microcaps, trade options, whatever.

These sorts of accounts have several advantages: first, they are relatively small, so if the investments crash and burn, there is little harm done to your net worth. Indeed, it might even help prevent speculation with your real money, which could result in catastrophic losses.

Second, if any trade works out, you can let it ride. It is much easier to say,  Sell your losers but hold onto your winners, than to actually do so. Try to find people who bought meaningful amounts of Apple Inc. circa 1997 or Inc. in 2009 and are still holding the shares today. When a trade works out so well it creates the equivalent of several decades worth of your normal earnings it is all but impossible to be unemotional and objective about it. Working with a small percentage of total assets avoids many of the usual loss-aversion issues that are so common.

Perhaps the most important lesson comes from Oliverez himself. “Even if you get a big payout from time to time, the longer you play the more you lose,” he said. That is smart, and it shows that he understands just how big a role luck played in his trade. So, let’s say congratulations to him, and learn the correct lessons from his successful speculation: Never confuse lucky gambles with a good investing strategy.

We discussed the trouble with anecdotes last month via Ray Wolfinger. He coined the original quote, “the plural of anecdote is data.” What he meant by this was that “anecdote might bevalid data leading to a potentially significant conclusion. For that reason, when an unusual anecdote captures one’s attention, it shouldn’t be casually dismissed, lest a deeper truth be missed.”

I suggest doing it at a different brokerage firm fromwhere you keep your real money. This makes it more difficult for you to transfer money into losing positions with merely a click.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Barry Ritholtz is a Bloomberg Opinion columnist. He founded Ritholtz Wealth Management and was chief executive and director of equity research at FusionIQ, a quantitative research firm. He is the author of “Bailout Nation.”

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