In short, many investors “never considered that the fact that trading on economic variables has worked in the past may have been merely coincidental, or, perhaps even worse that economic analysis was fit to past events to make the random element in it.”<!--[if !supportFootnotes]-->[3]<!--[endif]--> This generally occurs because the markets produce a vast amount of noise (random, short-term price/level movements that do not contribute to the overall long-term trend) that is often mistaken by market participants for information. Aside from the coincidental benefit of favorable returns, luck can also entail the temporary avoidance of a particular risk. In the case of LTCM (mentioned above), luck was the only reason that the fund did not blow up sooner than it did; many investors reap profits for years by taking on huge unseen risks, and are wiped out when their luck runs out and they experience a “black swan” event. The next passage elaborates upon this idea:

This also explains the inconsistency of prosperity. If one is cautious and patient in his method of proceeding and the times lend themselves to this kind of policy, he will prosper. But if the times and circumstances change, he will fail, for he will not alter his policy […] because having prospered in pursuing a particular method, he will not be persuaded to depart from it. Hence, when the times require it, the cautious man will not know how to act impetuously and he will be overthrown. If he were able to adapt his nature to changing times and circumstances, however, his fortunes would not change.

Because the lucky investor does not realize that he is lucky when things are going well, he will be caught off guard and suffer massive losses when his fortuitous circumstances change. (The adjectives cautious and impetuous in this case should not be taken literally, but instead serve as describing any two opposing methods or styles of investing.) Because he is ignorant of his luck (instead, attributing his success to skill), he will not change his methods when it becomes necessary to do so. One example of this is the fate of many internet start-up companies and their owners during the tech bubble; as the bubble pushed the valuations of these essentially worthless companies to their peak, many prudent entrepreneurs, realizing their serendipitous circumstances, sold their companies before their “value” evaporated. Others – attributing the success of their companies to their sheer entrepreneurial skill – continued to own and operate their businesses and were wiped out as their luck suddenly changed when the tech bubble finally burst. Machiavelli makes the point that the impact of luck, or more specifically bad luck, is most severe on the unprepared:

[..]The same can be said about fortune, which tends to show her strength where no resources are employed to check her. She turns her course toward those points where she knows there are no levees or dikes to restrain her.

Finally, Machiavelli offers his advice on how to operate, and perhaps succeed, in this type of randomness-prone environment:

Therefore, since fortune changes while human beings remain constant in their methods of conduct, I conclude that men will succeed so long as method and fortune are in harmony and they will fail when these are no longer in harmony. But I surely think that it is better to be impetuous that to be cautious, for fortune is a woman and in order to be mastered she must be jogged and beaten. And it may be noted that she submits more readily to boldness than to cold calculation.

(It should be noted that impetuous is used here as “moving with great force and energy” and not in its more common usage as “done without though as a reaction to an emotion or impulse”. Conversely, cautious is taken to mean “timid” or otherwise weak.) This concluding passage offers timeless advice to market participants: traders and investors must incessantly question their methods and beliefs – especially when things are going well. During periods of strong performance, it is easy to be lulled into a sense of false security, unquestioningly attributing success to an inherent skill. However, unless we continually and aggressively (or impetuously) test our methods and allow for the idea that some (or all) of our success can be the result of luck, we will be setting ourselves up for a huge loss if, and when, our fortunes change.

It applies today as it did 500 years ago!

RUF