Good luck can be bad, and sometimes we are right for the wrong reasons.
I worked with a company putting in a small market strategy. The idea was to put units with a subset of product in smaller markets. The idea was a good one, the plans were fine, but the implementation was fumbled when the test units were all placed in large markets. Instead of testing a small market strategy, they tested a small unit strategy. The results exceeded expectations. The small units performed great and a major investment initiative was undertaken. Several years profits were dumped quickly into new units. Unfortunately, the investments were made in small markets where results were nothing like the test markets. The next management team (and there is always a next management team) spent over five years shuttering these units while the stock dropped 90%.
Investments are made incrementally: a decision is made, an action implemented, a result is achieved. We review our results and make the next decision. When we get a good result based on a bad process, we change our criteria and understanding of the investment cycle.
When a good result happens after a bad decision process, management is mislead. Now the bad decision process gains momentum. Further decisions follow the bad process and the odds of further problems increase. The factor that caused the good result (big competitor leaving the market, change in government policy, innovation) is also not examined or recognized. The management team attributes their success to something else, usually their own intuition or skill. Humility is an executive management teams best friend. Over confidence and hubris precede the fall. One portfolio manager I worked with was especially skilled at identifying overconfidence in management teams.
When you have a good decision process you can still get a bad result. After all, business is about taking on risk. If it isn’t risky, investing in a business would be like investing in a bond. It is not.
When you follow a good investment process and lose, you can second guess your process or implementation schemes, or you can identify some other relevant factor. Sometimes, as they say “crap happens”, the market, customer, technology. competition change and your results are bad. Of course, some firms don’t look too closely at the results of their decisions. No one wants to admit error, especially a CEO who has committed personal power to a particular course of action.
How do you avoid this? It’s not as easy as remaining humble. Good decision processes are defined by good results. Taking the long odds when the payoff is low is stupid. But in business, the odds are not apparent as they are in a book about poker or on the tote board at the horse race track. Risk is estimated and a good result tends to lower our assessment of the bad risks and increase the upside potential. Often a careful review will identify unknown variables that mitigated the risk. Sometimes a counterfactual is helpful as a tool to identify whether your risk assessment is accurate. For example, what if the competitor in this market hadn’t closed the month after our opening?
Often we just need to update our assumptions slowly and continue to gather information as we move through the process. Another couple of test units would have helped, or a second review of the market size after the units are open to see if they remained classified as “small markets”.
Luck can be bad or good. Both can mislead. And sometimes, when you have positive luck, and the sun shines seven days in a row, enjoy it.