Turning luck into value

Valuers are concerned with making financial decisions; should you sell or buy, invest or not or pursue one strategy or another.

As a result, the object of good valuation is to make better decisions. However, experienced valuers (and good bookmakers) know that it is impossible for every decision to work out in your favour – and conversely you can sometimes make a clanger – which ends up turning out superbly.

In fact, there is a dichotomy between good decisions and the outcomes of those decisions. The thing that cleaves the two – plain old luck!

We all want good outcomes and we reward those who achieve them for us. But if luck plays a role, should we really just reward good outcomes?

The nature of luck

We live in a random world. 

However, the human mind is a curious thing, and doesn’t like randomness; we seek to explain every event rather than just recognise that many things happen because of where the ball settles on the cosmic roulette wheel. Superstitions are one phenomenon that we use to explain randomness.

Yet randomness is everywhere. This randomness arises from natural variation, information gaps and the fact that many systems we operate in are chaotic (that is they have so many interactions that the outcomes are unpredictable even if you understand each individual interaction).

The extent of randomness has been studied in fields as far as sports, weather forecasting and investment.

Just how much luck is involved

In his excellent book, Michael Maboussin[1], looked at how much luck versus was involved in various fields. Others have built on this work in the sporting field, which is summarised in the infographic below (sourced from Post-Gazette):

Mr Mauboussin also looked at investing. Even though he acknowledged that many investors are highly skilled, the impact of competition between them meant that outperformance in any given period (and even over several periods) was largely down to luck.

It seems remote that luck would exist in the investing world and not in any other financial realm.

Managing for luck

So, if we acknowledge the existence of luck, we need to think about how to manage in a luck-filled environment. 

Here are a few suggestions gathered from worlds of high uncertainty as far and wide as poker and the movie business:

• Grab opportunities – randomness produces many things that you don’t expect. Grab onto the good ones! Old time mothers may have offered advice to their daughters that they have to kiss a few frogs to meet a prince, but in the game of life, they were right! If you are not in the game, then it is pretty hard to grab the opportunities that present themselves.
• When things go well, follow though – you don’t know when good luck is going to hit, so you need to make the most of it.  Movie makers have understood this for years, it’s hard to find a hit, but when you find one capitalise on it - which is why we see lots of sequels!
• Trim the downside– the worst case scenario is often a daunting (if remote) prospect. Making sure that you take out insurance if the worst happens means that you will still be in the game if it happens. Think rock climbers using a static line - if they lose their grip; it's not fun if they do but they have a better outcome than free climbers!
• Don’t over analyse – focus on the key drivers and the variation around them. The existence of randomness or luck means that even the most polished analysis may not survive contact with reality. When faced with this concern, it doesn’t make a lot of sense to spend a lot of time refining your analysis to the nth degree. Just work out what factors might change the decision and spend more time understanding the risk around those factors. This will have the twin benefits of speeding up your decisions and making them more risk aware. In high risk medical fields, triage performs this critical role.
• Experiment where the uncertainty is high (and luck makes most of the difference) – this is one way of making your own luck. If you don’t know much, borrow from science and conduct lots of experiments to see what works - but don't bet the house when you are not sure. That way you will expose yourself to more good luck – and even if you have bad luck you won’t spend much! Wildcatters in the resource game intimately understand this equation. 
• Reward good process and evidence of skill, not just outcome – if luck is such a large factor in eventual success (especially in one off events, which describes many big moments in business), rewarding outcomes alone seems to reward both the lucky and the skilful in roughly equal proportions. Whilst Napoleon wanted lucky generals not just skilful ones, playing for luck alone doesn’t seem like a winning long term strategy. Accordingly when managing and rewarding your team, focus on both good outcomes and good skills/processes; they both count over time – that’s why sports teams and investment professionals still want and pay good players even though they know that luck plays a part.

Key takeaways

Luck – or at least randomness is everywhere. Even in the most skilful of fields luck plays a significant role, because competitors are often equally skilled, cancelling out the impact of skill on outcome.

To ignore luck then seems to ignore one of the major contributors to corporate success. Accordingly, once you have obtained the necessary skills (including good processes), you need to manage your luck as well.

By using techniques gathered from high uncertainty situations, you can tilt the scales of nature's lucky balance in your direction.

-------------------------------------------------------------------------------------------------------------Richard Stewart OAM is a Corporate Value Advisory partner with PwC. He has been with them for 34 years in Australia, Europe and the USA, doing his first valuation in 1992. He has helped his clients achieve great outcomes using his value skills in the context of major decisions, M&A, disputes and regulatory matters. His clients span both the globe and the industry spectrum. He holds a BEc, MBA, FCA, FCPA, SFFin, FAICD and is an accredited Business Valuation Specialist with CAANZ. He has written two books, Strategic Value (2012), and Hitting Pay Dirt (2017). He is also an Adjunct Professor at UTS and a non-executive director on two not for profits. Any opinions in this article are the authors alone, and do not constitute investment advice.

[1] The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing, Harvard Business Review Press; 10.7.2012 edition (November 6, 2012)