STE's Stocks Investing Journey
Skill vs Luck in Investing
We always attribute our success in life or any aspect in life ( e.g career development /doing business / investing ) to our skill or performance but does "luck" has any place in these successful events.
If we think that skill ( talent ) play a very important roles in investing ,, then you may find that some very talented or intelligent people fail in investing ( e.g Newton ) , and if you think that investing is purely on luck , then we may have puzzle to explain the success of great investors like Warren Buffett or Peter Lynn and others in beating the markets for multiple years .
In short term , may be luck play as events tends to be in random , but in the long run , the skills will be vital to achieve returns which would beat the market or so call " Alpha "
Coin Flipping :
The famous coin flipping story from Warren Buffett which imply the luck factors in short term random event :
Buffett draws an analogy between money managers and stock pickers (like him) and participants in a national coin-flipping contest。
Imagine you get 225 million people (the approximate population of the U.S. at the time) to participate in a coin-flipping contest. Each person bets $1 and flips a coin. "If they call correctly, they win a dollar from those who called wrong. Each day the losers drop out, and on the subsequent day the stakes build as all previous winnings are put on the line," Buffett wrote.In day twenty, we have 215 people left and with each one have wining stake of 1 million each .
Those people can probably write a books on 'How I Turned a Dollar into a Million in Twenty Days Working ".
Although this is just a story on pure luck , but in most case people or fund manager would deem the short term luck couple with " over confidence " biases that contributed to their "over perform " in short term to be skills.
The Paradox of Skill :
This story may be too extreme in relating luck to investing but how about those skillful fund managers with super-fast computer and sophisticated modelling to pick the right stocks and forecasting their future growth.
In the book title " Incredible Shrinking Alpha " , the Authors Swedroe & Berkin define the Paradox of Skill as below :
"What so many people fail to comprehend is that in many forms of competition , such as chess , poker or investing , it is the relative level of skill that plays the more important role in determining outcomes , not the absolute level. What is referred to as the " Paradox of Skill" means that even as skill level rises , luck can become more important in determining outcomes if the level of competition is also rising ."
According to Michael Mauboussin, former Chief Investment Strategist at Legg Mason Capital Management, looked at the historical data on the percent of equity mutual funds that beat the market during Value Trust's 15-year streak. Because the number of equity mutual funds beating the market fell as low as 8% in one year and 13% in another, he estimated the probability of beating the market in the 15 years ending 2005 was 1 in 2.3 million.
The Hot Hand in Investing :
In the Book title " More Than You Know , M Mauboussin also explain the phenomena of " Hot hand " in investing. " Human are natural "pattern seeker ". One well-know example is the Hot Hand in basketball. A player who make a few baskets in a row is considered to have a hot hand , which implied that he has a higher-than-normal chance of hitting the next shot. " said Mauboussin.
According to him , we see patterns where none exist because we are wired to expect that the characteristics of chance show up not just in a total sequence but also in small parts of the sequence. Behavioral economist Amos Tversky and Daniel Kahneman call this " belief in the law of small numbers."
In selling their fund from Bank or Insurance company will always show you the "winners" or the best fund,,, which most of the time also as a result or affected by " Survivorship bias " when the weakest already being eliminated .
But what about " Warren Buffett " ? ,,, just look at above probability , one require 1 in 2.3 million to beat the market in 15 years , in Warren's case , who has out -perform the market in over 40 years ,, what will be the probability among the fund mangers ?? may be close to 1 over 100 mil ??
So , what do you think our skill can out-perform the market ? else , we may opts for more passive ways of investing like " ETF ". If we think we can try to beat the market with lower % point than Warren Buffett ,,, then by all means , please proceed with this challenge in picking your own stocks and portfolio .
Human being like to have challenging task ! by nature ....
Cheers !!
PS : Further Reading
A very good link about " Luck vs Skill in Active Management Fund " from famous Blogger and Author : Ben Calson ( A Wealth of Common Sense ).
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This book is the result of the author's many years of experience and observation throughout his 26 years in the stockbroking industry. It was written for general public to learn to invest based on facts and not on fantasies or hearsay....
