The One Investing Variable Most Traders Refuse to Acknowledge

In the immortal words of Dirty Harry Callahan, "You've got to ask yourself one question: 'Do I feel lucky?' Well, do ya, punk?"

That is the question market participants should consider every time they put money on the line because there is no sure thing in the stock market. If you are an investor, you are, to some extent, also a professional gambler.

Luck plays a larger role in the investing business than most of us will acknowledge. It cuts both ways. The small position that runs without you is good luck. The properly sized entry that falls apart the next morning is bad luck. The stop hit at the exact low and the breakout that holds for no clear reason are the same phenomenon from opposite sides. Neither was earned, and neither was deserved. They happen, and they will keep happening, and we will be on both ends of them as long as we trade.

Crediting skill for wins inflates the sense that we have an edge, which leads to bigger size and looser discipline on the next trade.

Our natural response is to credit the wins to skill and blame the losses on luck. Most of us do this without noticing. The good trade was insight. The bad trade was the market behaving unfairly. In hindsight, when a trade works, the logic we used is pure and obvious, but when it fails, it is because of bad luck. Same trader, same process, two completely different stories depending on the outcome.

Crediting skill for wins inflates the sense that we have an edge, which leads to bigger size and looser discipline on the next trade. Blaming luck for losses means nothing gets learned from them. Both errors push us toward overcorrecting and make trades that set us up for more severe damage the next time.

The reality is that most wins have some element of luck in them, and most losses have skill failures in them. Not always, and not in the same proportion, but the trader who assumes the reverse of the natural human move will be closer to the truth than the trader who indulges it.

What Wall Street Doesn't Want You to Think About

The financial industry feeds the inclination to deny the role of luck in investing because it undermines its value. Advisors, funds, pundits, newsletters and all of Wall Street are selling their expertise. Every one of these requires the customer to believe that what worked was skill and what will work is more skill.

Acknowledging luck honestly would mean acknowledging that some portion of every track record is just plain luck and some portion of every recommendation is a guess. There are many people on Wall Street who have made a career after one timely and lucky prediction. That is the reality of all investing, but it is not a story Wall Street wants you to contemplate.

Making It More Than a Coin Flip

Dealing with luck falls on your shoulders. No one else is going to do it for you. The trader who wants to survive long term has to develop a methodology that accounts for luck before luck shows up.

What separates the stock market from a coin flip is that the trader can shift their exposure to luck. The more you know about the stock, the technical setup, market conditions, and the economy, the better positioned you are to build a methodology that accounts for it. Gary Player said the harder I work, the luckier I get. The same applies in the market.

One simple example is avoiding major events like an earnings report or an FDA decision. If you hold positions into news of that sort, you are far more exposed to luck than if you do not. Do the work to know when you are most vulnerable to luck.

We tend to think of a trading methodology as a way to identify good trades. Setups, indicators, and fundamentals are half of it. The other half is the structure that determines what we do when luck arrives.

Position sizing limits the damage from the bad-luck trade we could not have known was coming. Stops curb the loss before it becomes catastrophic. Partial profits capture the good-luck mover before it gives back the gain.

A methodology that does not account for luck is not really a methodology. It is just an opinion, and an opinion is not much different from betting on a coin flip. The trader following it will do fine when conditions cooperate and will get hurt when they do not. The difference between the two outcomes has less to do with the quality of the analysis than with the luck of when the trader happened to be using it.

A Different Mindset

The methodology that deals with luck involves a different mindset. It assumes from the start that some percentage of trades will be touched by something we cannot anticipate. It is an admission that we cannot predict the future. It is designed so that bad-luck trades cannot compound damage, and so good-luck trades have room to run.

The goal is to use structure rather than prediction, because it's in prediction that luck does its damage. We cannot eliminate luck. We cannot predict it. What we can do is prepare for its arrival.

Preparing for both good and bad luck is much harder than it sounds, but it lies at the center of investing success. The first step is to recognize the inevitability of luck.

Luck is not something we can control. Surprises are inevitable. There is no shame in that. The only failure comes when we refuse to acknowledge how much luck plays a part in what we do.

At the time of publication, Rev Shark had no positions in any securities mentioned.