Friday, October 22, 2010

Is Investing Luck, Skill or Patience?

Periodically, we hear about this or that person who called the market top, who predicted a major downturn--or, sometimes, a mutual fund manager who managed to beat the market by some astronomical amount.  Last year was no exception: for example, one fund was up 122.05% in --which, of course, means that its investors would have doubled their money if they'd invested at the start of the year and held on for the next 12 months.

These people are geniuses, right?

Wrong.  The simple law of averages says that somebody, somewhere, will have a streak of correct predictions or hold stocks that dramatically outperform the markets for a year or two.  Certain unsavory people who hung out at race tracks knew how to make money at this game; they would go around the track telling some people that Horse A was going to win the next race, others that Horse B was a shoo-in, and still others to put their money on Horses C, D and E.

Then, if horse D won the race, the crooked tout would go back to the people for whom he had "correctly" predicted the outcome, and offer to give them more "inside tips" for a generous fee.

To see how the normal patterns of luck can bring about even the most extraordinary results, imagine that instead of managing investment portfolios, we were talking about people who flipped coins in a huge nationwide contest.  <>On Day One of the contest, 300 million people flip their coins, and those whose coin comes up tails are out of the contest.  By the law of averages, 150 million (or so) people will be able to play the game on Day Two, and after they flip, the number of contestants will have shrunk to 75 million.

Then come Day Three 37.5 million left, Day Four, almost 19 million, Day Five, 9 or so million and by the end of three weeks only 144 people are left.  All of the ‘amateurs’ have been weeded out.  In newspaper accounts, these are all described as remarkable coin flippers who somehow managed to throw a coin in the air and have it land on heads 21 consecutive times.  This is exactly what would be predicted by the law of averages, but now, suddenly, reporters in each city are interviewing their local champion, asking about their "winning techniques."  And, of course, the local champions are starting to believe in their own remarkable coin-flipping skills, telling their friends and the press about their wrist movements and the preferred height of the coin toss.

The next day, only 72 of these highly-skilled coin flippers are left, and the following day, just 36, and as the number diminishes, as the number of consecutive flips goes up, the media attention becomes frenzied.  Eighteen, then nine, then four finalists are flown to Hollywood for the nationally-televised coin flipping face-off, and all America believes in the skills that allowed these remarkable people to consistently cause a coin to land with the head of the coin facing up.

Finally, two flips later (maybe three), there is a winner--and who can seriously believe that this person managed to get a coin to land on heads 29 or 30 consecutive times without a tremendous amount of coin-flipping skill?

When one or two of the 8,000 mutual funds break dramatically from the pack in any one year, this is no more than what the law of averages would predict.  Yet investors flock into these funds, believing in their stellar investment skill.  The next time these winning managers confidently flip the coin, it just as likely turns up tails, the performance falls back into the pack, and experts call it "reverting to the mean", which just means that their luck ran out and they became normal again.  Investors put their money in too late to catch the first remarkable flip, but just in time to catch the fall, the return to normalcy.  It is the oldest trap in the book, and it sucks away billions from retirement accounts.

There ARE excellent fund managers, but you rarely see them break from the pack, and if they do, they will be the first to tell you that there was as much luck as skill involved.  Sometimes, a great manager will experience a terrible year, for the same reasons.  Investing is a game where you take the luck that is offered you, and inevitably you give something back when the luck runs out.  Those investors who are patient and careful and humble in the face of this reality, who don't chase the hot coin flipper right after a great run, will usually win more often than they lose--because, unlike a casino, the odds in the investment markets have, over most historical periods, tended to favor the patient investor.  The markets go up more than they go down, and so you can have more than your share of coin flips going your way with no more skill than the patience to stay invested.

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