Luck, Skill and the Human Condition
It’s funny how those who are successful most often attribute their success to their own skill and those who are less so attribute their misfortunes to bad luck. The truth is it’s very hard to determine what is luck and what is skill. Especially a posteriori. This is particularly so in the investment world. Let’s say you decide to purchase a stock and it immediately goes up. You pat yourself on the back and say “Good job! You were really smart to purchase stock in XYZ company when you did.” Of course that’s absurd! First of all you probably didn’t purchase the stock thinking that it would go up right away (otherwise you’re not an investor but a speculator!). So why are you patting yourself on the back? I think the answer is, being right makes us feel good. And making money while being right even more so. So we really like to ‘be right’ about an investment. It’s fulfilling. We convince ourselves that ‘we were right to pick that stock’, rather than ‘Oh how lucky that the stock went up after I bought it’. Being lucky doesn’t exactly produce the same high.
The truth is, one can almost never be sure whether skill is involved in picking a certain stock. Yes, we can be more certain that skill is involved as the sample size gets larger, i.e. more picks. But still, we know that you can be right calling a coin flip 10 times in a row and you’re still just lucky. 100 times in a row and you’re just luckier. (That is, I think so, as no one has yet been able to call a coin flip a million times in a row. But is it ever really knowable?) The same can be said of picking stocks. Picking 10 winners over a year might easily be just luck. 100 winners over 10 years begins to look less like luck, but in fact it could be just luckier. After all, if you have enough stock pickers, one is bound to get it right! Its just math (or probability, in this case). But experience tells us that in most instances its true what they print on mutual fund prospectuses; ‘Past performance is no indication of future returns’ or some such. So how can we be sure that we are adding value, ‘skill’, in our investment practice? If we can’t be sure about adding value, and thus skill, shouldn’t we just resign ourselves to investing in low-cost index funds?
I’m not sure I can provide an unbiased answer to that question. Perhaps its illogical but there’s something in me that says there must be a way to produce superior returns. So when I see studies showing that value investing produces market-beating returns I feel immediately relieved. I like that answer to the active vs. passive investing conundrum. So am I being biased in accepting those studies as proof? I’m not sure. The indexers have a point. You just put your money in an index fund and let it sit there. It produces good returns over the long-term. Most of the time better than the active managers collectively. But then there’s this little voice inside my head saying it’s not all about cut and dry returns; you have to consider human emotions (especially your own). Why is it that the average investor’s return in a mutual fund is far inferior to the mutual fund’s long-term performance? The answer is simple; most investors pull money out at the bottom of the market and put money in at the top. I want to avoid that at all costs; that’s the kiss of death for investment returns. So I’ve tried to adopt a strategy that embraces value investing but addresses the emotional aspect of investing. My strategy is a kind of value approach where I only invest when I’m confident that I’m buying a dollar’s worth of a company for less than dollar and leaving whatever’s left of my investment funds in cash, as a kind of countermeasure to the emotional side of investing. Take this moment in the market for example. I’m less than 50% invested in equities. I just can’t find the kind of value I want for the prices being offered at the current ‘risk’ level. It’s been that way for over a year, so I’ve missed much of the market appreciation over that time. But I sleep well at night. I know that if the market falls 50% I’ll have cash to load up on shares; I have my wish list ready. I’m not really worried about not catching that 10% upside. I want to be emotionally ready when the market drops 50% to put my money at risk. Just ask yourself, if you have 95% of your savings invested in equities and the value of your portfolio dropped 50% would you be in the appropriate emotional state to invest the remaining 5%? or even to leverage up on margin? knowing that you have a mortgage to pay, a family to feed, health bills to pay… and your job security is becoming more and more tenuous as the overall business outlook dims? I know I wouldn’t! So I’d rather forsake the certainty of index investing for the relative emotional calm of my value investing strategy. It’s funny, the secret of success with both strategies is the same, patience, but one requires more emotional resilience, a resilience I’m not sure I have.