Bill James an article back in 2004 that deserves a read titled “Underestimating the Fog” (Baseball Research Journal No. 33, 2004). The article talks about using statistics to test hypothesis about baseball. The questions he asked dealt with whether a good catcher helps a pitcher or whether there is such a thing as clutch hitting.
Some questions can be answered through statistical analysis and some cannot. Mr. James is talking about problems that cannot be solved with the amount of data we have at hand. The fog is the uncertainty in the underlying data, which is sufficiently random enough to swamp the small effects of the particular question we are examining. Some questions, Mr. James states, will never be answered using these tools. The nature of the game won’t generate enough data, and the randomness of each factor is significantly higher than the effect we are trying to isolate. Mr. James concludes that his tools may not be good enough to see through the fog to identify if there is real skill. There is too much random noise to know for sure.
Business has a lot more fog than baseball. Baseball has a rulebook, trained umpires and is played by highly skilled individuals that have taken years to become the best. Business has no rulebook, there are no umpires and there are no playoffs and no finish line. The amount of randomness and volatility in life is so much greater than in any sport.
In business strategy selection is often done in a cloud of uncertainty and random factors. Often the factors outside our control will make the most significant differences in results, without regard to the strategy we select. Ignoring these random factors is pretending that there is nothing bad (or good) hidden in the fog. How then do we pick a strategy, since we may not control the market, or the competitors, innovation or what the Fed decides tomorrow? I suggest three things to focus on.
Be Prepared to be Lucky
I wrote up a company as a buy once and coaxed some clients into investing. Within a couple of months the company was bought at a significant premium to the original stock price. My analysis did not consider a potential buy-out (although they paid remarkably close to my target market price) and I hadn’t expected a buyout. In this case I was lucky – not good. Acquisitions, good and bad news, CEO turnover, product failures and successes can’t always be foreseen by investors.However, you can be in a position that if you are lucky, you get paid.
I like the real option approach, akin to the Scott Adams approach in his book “How to Fail at Almost Everything and Still Win Big: Kind of the Story of My Life”. A real option is a right to do something but not the obligation. Mr. Adams spent years looking for projects that could result in success. If circumstances were favorable he invested in the project, if not, he abandoned. From an investment perspective, buying value stocks is about investing in undervalued companies that are improving, with the hope that a) they will continue to improve and b) others will notice and bid up the stock price. And sometimes you get lucky and the firm gets bought out.
There is an old saying about “the harder I work the luckier I get”. Usually old sayings are repeated because there is a kernel of truth. Being prepared to be lucky means you have to be prepared for success.
Be Prepared to be Unlucky
The one thing portfolio managers do better than individual investors is that they are prepared to sell when they are wrong. Sometimes luck doesn’t work in your favor. I have a client where a key customer has lost 50% of their business due to new state regulations that were unfavorable. Sometimes shit just happens. Being prepared for luck to work against you means having back up plans and reacting quickly and appropriately as new information is learned.
Charlie Munger recommends decision trees, where he plots out how circumstance, action and luck will generate results based on the probabilities assigned. Mr. Munger is planning on both good and bad luck and still looking for a positive result.
Unfortunately what we often define as “bad” luck is just the absence of good luck. You can’t plan a July wedding in Michigan and not plan for rain.
Be Prepared for more Fog
Mr. James concludes his article “…we may have underestimated the density of the fog. The randomness of the data is the fog. What I am saying in this article is that the fog may be many times more dense than we have been allowing for. Let’s look again; let’s give the fog a little more credit. Let’s not be too sure that we haven’t been missing something important.”
The fog of business shouldn’t preclude us from selecting a strategy. There are random factors that can outweigh our actions within the firm. Recognizing the fog is thick means planning for volatility both random and systematic. Because we can’t see through the fog, it shouldn’t make us think there is nothing in the fog, or that we can’t make plans or investments.
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Dr. John Zott is the CFO for Carlson Wireless Technologies, and Principal consultant at Bates Creek Consulting. John is the chair of the Careers Committee at FEI Silicon Valley, a senior adjunct professor at Golden Gate University and comments regularly on issues that affect consumer businesses. If you are a former student, colleague or would just like to connect – reach out.