How much of a role does luck actually play in business?
The football season is kicking off. Can Leicester City repeat last season’s performance? Maybe it can, but the football club, just like companies and investment strategies, may get hit by the curse of regression to the mean.
As a whole, us, that’s homo sapiens, are not good with probability. We get fooled by randomness, as Nassim Taleb might have put it, all the time.
And there is a little idea, known as regression to the mean, that tells the story.
But let me start with the late, as opposed to the new, Duke of Westminster. He was once asked if he had any advice for people in business, or investors, on how to emulate his success. He replied that he thought it would be a good strategy if they could make sure one of their direct ancestors was a very close friend of William the Conqueror.
It was a nice response, a wealthy man acknowledging the role of luck that enabled him, and indeed his family to become so rich. We can have a separate conversation about inheritance tax, but that is a debate for another day.
Truth is, luck is something that happens.
Someone wins the lottery – although I am still seething over the returns policy of my local lottery ticket vendor. Some people win the lottery of life, or indeed investment.
Let’s say there are 20 teams in a football league. Let’s say some teams are better than others. Let’s say ‘Brilliant Team United’ boasts some of the best players in the world in its line-up. Let’s say, Jester City don’t. There is still a chance that the Jesters will beat United. Let’s say the odds are 30 per cent of a Jester win, 50% of a United Win, and the difference relates to a draw.
The law of averages says that the Jesters will win from time to time, and that from time to time they will win rather a lot.
Now as it happens there are 20 clubs in the Premiership. The law of averages says that from time to time clubs boasting an inferior side on paper will win lots of matches. It has nothing to do with form, or gritty determination, study of probability tells you this will happen.
In 1994/95, Blackburn Rovers won the Premier League. Four years later they were relegated.
Did they win in ‘94/95 thanks to brilliant play and the genius tactics of coach Kenny Dalglish? Or was their victory just something the laws of probability say should happen from time to time?
Regression to the mean says that in the long run most of us are average – which I guess is a truism– but we can get fooled by one-off successes that are down to randomness into thinking we are far from average.
Will Leicester City get struck down by regression to the mean this year, or was their win last year more to with skill than luck?
Its similar with fund managers. Sometimes a fund manager enjoys rare success, year after year. But it may simply be that randomness had picked our fund manager out, and regression to the mean follows. Years of exceptional performance are followed by years of awful performance.
Apple may fall victim. Much of its success has been down to brilliance – ignoring research that said no one wanted a touch screen phone and literally changing the world with its iPhone.
But we know that its current crop of products won’t last forever. Can it repeat past success? Can it do with a car, or an augmented reality device, what it did with an MP3 player, smart phone and keyboard-less computer? Or will it get struck by regression to the mean?
The savvy understands this; they get around it by diversifying, experimenting, and are willing to fail, providing they fail quick and ensure they have plenty of chances to try again.