- Scientific research shows that there is skill in financial markets.
- There’s a way you can test to see whether you’re just lucky or really skilled.
- I’ll perhaps surprise you at the end, but neither luck nor skill matter.
One topic I find interesting to discuss is whether investing returns are more a matter of luck or skill. Some things go up in price and make you feel like a genius when you were really just plain lucky, while other investments end badly but were a smart thing to invest in at the time.
In a bull market of 8 years, many start thinking that the possibility of losing money is remote thanks to the skills they’ve developed over the last few years only to be met with a very cold shower when the luck of the bull market ends.
Today I’ll discuss how to determine if your past investing returns were a matter of luck or skill. This will help you in making better investing decisions in the future, and is extremely important at this point in time when stocks are at extreme highs.
Fund Manager Skill Versus Luck
Wharton professor Jules van Bisbergen, and Johnatan Berk from Stanford analyzed 6,000 mutual funds in a period from 1969 to 2011 and found that there were funds that outperformed constantly over longer than 10 year spans. However, as soon as a good track record emerges, the fund is flooded with money which makes it difficult to operate at the same profitability level as size is the enemy of all funds. Just think of Buffett’s returns of over 20% during his early years and current targeted returns of around 10%.
Another thing that negatively impacts investors’ returns is that funds with skill can charge more for that skill which usually leads to again average returns. Only those who invest in the early stages in such skilled funds reap extraordinary returns as the fees are still low and the fund can play on size. Nevertheless, the point here for individual investors is that skill matters and if you give yourself the time to achieve that skill, you can expect satisfying returns over time.
Highly Skilled Competitive Environment
Another point that makes it extremely difficult to compete in the stock market even if you have the necessary skills is that there are many others who have the same skills, which makes it a tough environment to be in. However, there is a way to test whether you are lucky or skillful and it’s an exercise that every investor should do.
Are You Lucky Or Skilled?
The easiest way to determine whether you are lucky or skilled is to try to lose on purpose.
If you can lose money on purpose or at least underperform the market on purpose, then you can consider yourself skilled enough in the stock market. Of course, this again has to pass the test of time. However, when you research what to buy, try to also think about what you would sell. If you can find investments that will definitely lose money, you are skilled. Of course, going short on those should be the thing to do.
However, whatever happens in our lives, the left hemisphere of our brain is made so that it immediately finds a cause to an effect and no matter what it will try to simplify the environment we are in.
What You Should Do
Charlie Munger explains this in a very simple way: just avoid doing stupid things over your lifetime and your investing returns will be satisfying.
What does he mean by ‘stupid things’? Stupid thing are investments that carry huge risk, which brings me to why neither luck nor skill matter.
Let’s say there is a 70% chance that over the next 20 years the cumulative returns from the S&P 500 are negative, a 20% chance that annual returns are 4% per year, and a 10% chance that annual returns are above 10% per year for the next 20 years.
Now imagine you say the risk reward of my scenarios are too risky for your personal investing goals and you don’t invest in the S&P 500 but invest instead in some stocks that deliver 6% annually over the next 20 years with much less risk while the S&P 500 actually delivers more than 10% per year. Of course 20 years from now, you would kick yourself for not investing in the S&P 500 because that is how we humans act. Nevertheless, the 6% would have probably led you to your financial goals and you would have done it by sleeping well which is the most important thing when investing.
I’ll leave you with this, it doesn’t really matter whether you beat the market or not, what matters is for you to achieve your financial goals. That’s it. And believe me, reaching your financial goals is a lot easier over the long term if you avoid doing stupid things over time with the hope to be lucky or due to overconfidence in your skills. You might get lucky once or twice, but if the third time you lose everything, the total return won’t amount to much.
The best thing to do is to simply focus on the businesses you own, their earnings returns will give you your long term returns and if you invest like that, you won’t care less what the market does.
As an example, Walter Schloss, the legendary Graham student that outperformed the S&P 500 by about 10 percentage points per year over an almost 50-year time span, underperformed the S&P 500 from 1989 to 1998 by a cumulative 50%. Nevertheless, by 2002, Schloss had again beaten the S&P 500 by a significant margin.
So, be patient, find the investing style that fits your goals, and you’ll need neither luck nor skill. You’ll just need simple common sense and you’ll do just fine over time.