Is investing luck or skill? According to the Efficient Market Hypothesis (EMH), no one can beat the market. Usually we talk about the “dart flinging monkey” will get better results than individual stock pickers. There is truth to this, as research suggests that most professionals under-perform the indexes. If monkeys do better than individuals, why even bother?
Index And You Don’t Need to Think
I do recommend indexing to the vast majority of individuals. Its an easy way to put your money into autopilot and there is no need to know anything about businesses or finance. But since this blog is about investing as a practice and aimed at those who wish to do better than average with less risk, we need to address the question of luck vs. skill more closely.
In his latest memo, “You Bet!” (Jan 13, 2020) Howard Marks writes that (paraphrasing): “We evaluate decision quality based on the outcome. If the outcome is a win, we assume the decision was good. If its a loss, the decision was wrong.” There are moments in our lives decision-making where this may hold true. In investing “What makes a decision great is not that it has a great outcome. A great decision is the result of a good process, and that process must include an attempt to accurately represent our own state of knowledge.” -Howard Marks.
Luck may play a role, but we must work on getting the odds in our favour. A perfectly reasoned, rational investment may turn out bad. This doesn’t mean that the decision was “wrong”. In order to get the odds in our favour, we need to be focused on the process, not the end-goal. Having a wrong process may still result in a win, but doing this repeatedly puts the odds against you in the long-run.
Efficient Markets and Monkeys
By the 1980’s the EMH had established itself as dogma. In 1984 Warren Buffett wrote an article in the Columbia Business School Magazine titled: “The Superinvestors of Graham-and-Dodsville”. The article shows how a number of fund managers have been able to consistently outperform the market, all while the EMH is being taught at all business schools. I’ve read the article, and copying it word to word would be tedious. Essentially, Buffett destroys the EMH:
“Let’s establish the scene: All monkeys from all Zoo’s in the country are throwing darts. On average, their results represent market. However out of all the monkeys, a small number are beating the market, throwing bulls-eye darts. It is no surprise that there are outliers. But what if you were told that all of these market beating monkeys come from the same zoo, in the same city and are fed by the same zookeeper? You would of course be intrigued to know what on earth the zookeeper is feeding them.”
What these monkeys have in common is a process. That process is focusing on buying things less than what they are worth, ignoring the street (pun intended), and sticking within their circle of competence. The “secret” to doing well in investing has long been out, yet human nature is the biggest obstacle. Humans have evolved as a group. We get excited when others get excited and fearful when others get fearful. No matter how automated markets are, human nature will from time to time still be exposed in it. So is investing luck or skill? We can’t control luck, but if we work hard on the skill (process) part, we may tip luck into our favor from time to time.
-IGTSKasimir
Further Reading
Warren Buffett – The Partnership Days (1956 – 1969)
Philip A. Fisher – Lessons From The 15% Man
The Best of Ben Graham – Security Analysis
Phil Town – The Compounding River Guide
Margin of Safety – The Most Important Thing
Intelligent Investing = Thinking In Probabilities
The Emotional Stages of a Value Investor
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