Editor’s note: This article was first published in September 2015; the description of Google and Facebook as “two of the most profitable listed companies” reflects that time. Daniel Kahneman, quoted in the present tense, died in March 2024.
Is it luck that makes a company succeed or fail?
Mark Zuckerberg (Facebook), like Google’s founders (Larry Page and Sergey Brin), made serious entrepreneurial mistakes.
Zuckerberg decided to build a platform very similar to the one that dominated the market at the time (MySpace) and to launch his company without a business plan. He even took money from investors to keep paying for the infrastructure of “something” that wasn’t making a profit. He sensed he had something good on his hands, but he didn’t know how to monetise it. In fact, he didn’t know whether he could ever make it pay.
It is a typical case of entrepreneurs who don’t know where they are heading, and that is why Facebook was a resounding failure. In fact, a very predictable failure. Without a plan, it had failed before it even began.
Like Facebook, Google built a search engine that was somewhat better than what already existed, but search engines were not a profitable business, so they tried to sell it for a little under 1 million dollars. As was all too obvious, potential buyers found that far too expensive, since nobody would value a slight improvement in a search engine, and making money from it would be extremely difficult.
And that led to the failure of a company that called itself Google. Even the name was ugly and uncommercial.
This is roughly the explanation business school experts would have given us, as an example of what never to do when starting a business, if Google and Facebook had failed instead of becoming two of the most profitable listed companies of the moment.
In hindsight we can explain both success and failure
We can see the mistakes entrepreneurs made, as well as the good decisions they took, once we know they succeeded.
Nassim Taleb talked about this in his highly recommended book The Black Swan, where he is clear that Google and Facebook, like practically any tech company, owe their success to a single factor: pure luck. And that is something we are going to look at in depth.
The actions that lead you to success are exactly the same ones that lead you to failure
The truth is that the actions an entrepreneur takes that lift them to the top are exactly the same ones that sink them into failure. The problem, according to Nobel laureate Daniel Kahneman, is that we can only know whether actions were good or bad in hindsight.
In his book Thinking, Fast and Slow, he devotes several masterly chapters to this subject, to what he calls outcome bias. In hindsight we can explain anything, even while we are falling victim to ignoring our own ignorance.
Suppose a manager at a large company makes a risky decision and it leads to an increase in the company’s revenue. The media would talk about this manager as a visionary, someone unafraid of risk and with an incredible flair for business.
Now suppose the same risky decision goes wrong and profits fall. In that case, the manager would be described as irresponsible and a disaster at running companies; a reckless lunatic.
The thing is, to succeed you are going to have to take risks, and when you take risks, sometimes they turn out well (you’re brilliant at business) and sometimes they turn out badly (you’re an idiot with no talent for business).
But we shouldn’t distort these well-proven theories from psychology, because we are undoubtedly talking about talented people who will take risky decisions. If the results of those decisions are good, they will be written about in business books and held up as an example of how a company should be run. If those decisions turn out badly, nobody will talk about them, or they will be held up as an example of what not to do.
That is why so many pieces of advice for new entrepreneurs contradict each other. The explanation is that the advice successful people give is identical to the advice once given by others who ended up failing in business.
Seen this way, Kahneman’s theory makes sense when he says that success = talent + luck, while great success = a little more talent + a lot of luck.
A prudent person who doesn’t take risks, whether as an entrepreneur or as a manager, will go down in history as mediocre in their field, while someone who takes risks will go down in history as a visionary (if their decisions were right) or as a disaster (if their decisions led to dire results).
Manufacturing gurus
In a previous article we explained how to manufacture a “fake expert” in just a few days using nothing but credibility indicators. Being considered a guru in a particular field, and more specifically in investing, is usually manufactured in a very similar way, with nothing more than a little luck on your side. Or, failing that, statistics and probability.
Picture this system used by stock market “tipsters”. Imagine your professional standing is measured by the number of correct calls you make, where all you have to do is guess whether a share will go up or down before the company reports its results.
You take 200 people and tell 100 of them the share will go up, and the other 100 that it will go down. So you will be right with 50% of them. Next time, with the 100 people you were right with, you do the same thing: you tell 50 that a share will go up and the other 50 that it will go down.
At this point, 50 people have seen you get it right twice in a row. Doing the same a third time, you will be right with another 25 people. And three correct calls in a row are no longer seen as luck. So those 25 people will consider you a guru and would have no problem putting all their capital in your hands for you to manage.
After that you can play with the rest, making excuses for why your prediction failed, the most common being some unforeseen event that threw off your otherwise sound judgement. Either way, you can now write a book explaining your investment method for picking winners on the stock market and beating the market.
And the truth is that you will give the rest of the investing public advice similar to what those other investors who lose money give, because there is an inviolable rule in the world of investing: the most active investors lose more money on average.
That is why value investing remains the only investment method that consistently makes money for investors over the long term. The problem is that it delivers lower annual returns than those promised by other investors who claim to make much more money, but who, as a rule, have the ideal method for losing it.
Others, as is said to be the case with many of the big investment fund managers, take advantage of a three-year streak of good results to build themselves a strong reputation. After those past results, new investors come in and find that the fund no longer manages to generate those high returns. Why this happens is what Daniel Kahneman explains in Thinking, Fast and Slow when he talks about “regression to the mean”.
According to Kahneman, those who have done much better than average tend to do worse afterwards, and those who did terribly tend to do better in the following years.
Back to business: we can add more luck to our lives using “base rates”
“Base rates” are another concept that appears in psychological research, and Kahneman explains it in his book too. To explain what base rates are in a simple way that everyone can understand, we will use a few examples similar to the ones Kahneman uses.
In a city with 85 green taxis and 15 blue ones (85% green and 15% blue), if a taxi runs someone over and drives off, the police, in the absence of a witness, will know it is more likely that the taxi involved was green, because if we have nothing else to go on, it is more likely simply because there are many more of them.
If you put your hand into an urn looking for a red ball among yellow balls, your chances of pulling out a red one go up the more red balls there are. In other words, it is statistically unlikely that you will pull out a red ball if the urn held 1,000 yellow balls and only 2 red ones, just as you would have a 50% chance of pulling out the red ball if the urn held 500 yellow balls and 500 red ones.
Well, success in business, while acknowledging that luck plays a part, consists of raising the base rates. That is, steadily increasing the number of red balls in an urn that also holds yellow ones: success balls and failure balls.
Skill matters and adds “success balls” to the urn. Knowing the market also raises these base rates. Surrounding yourself with the right people, working hard, working smart and building strategies all add success balls, which might leave us with an urn of 1,000 balls, 800 of them success balls and 200 failure balls. And you have done everything right, but even doing the very best you could, you can still draw a yellow ball.
Success is statistical
Out of every 10 new internet companies, 8 fail. Many people find those figures terrifying. Read them another way. You have an urn with 10 balls, 8 yellow and 2 red. Keep drawing balls until you get a red one.
This is why it matters to keep trying after failing. According to Kahneman and the statistician Nassim Taleb, entrepreneurs who have succeeded after failing don’t owe that success to having learned from their failures (at least not entirely), but rather to pure statistics and probability. The more attempts, the higher the probability.
Of course, the more we raise those base rates with our attitude, aptitudes, skills and so on, the more we put the statistics in our favour.
That is why they say that in business you only have to get it right once to achieve great success. The rest is just drawing yellow balls.
To write this article I have brought together concepts I learned from these books:
- The Black Swan, by Nassim Taleb
- Thinking, Fast and Slow, by Daniel Kahneman
- Fooled by Randomness, by Nassim Taleb (although it uses many of the same concepts as The Black Swan, it is still worth reading)
Featured image: Charles J. Sharp, CC BY-SA 4.0, via Wikimedia Commons.
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