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Skill or Luck?

Philip Stein

NASSIM NICHOLAS TALEB has written a trilogy on the topic of chance: Fooled by Randomness, The Black Swan and Antifragile. I didn’t find these three books to be easy reading, plus Taleb has strong opinions, which may turn off some readers. Still, there’s a host of investment lessons to be culled from his works.

Taleb argues that randomness plays a powerful role in financial markets and, indeed, it influences market outcomes far more than most of us realize. One result: We’re often “fooled by randomness.”

According to Taleb, most active managers who beat the market over a few years are simply lucky—which may explain why persistent outperformance is so rare. He labels those who ascribe their market-beating results to skill as “lucky fools” since, more often than not, randomness—better known as luck—is the probable reason for their success.

Consider this thought experiment: You ask 10 people to flip a coin 10 times. It’s unlikely any one of them will flip, say, eight heads in a row. But if you ask 10,000 people, it’s highly likely that several will achieve this feat. With a large sample size, you should expect there to be several “successful” coin flippers. Such is the nature of randomness. Long streaks of positive and negative events do occur, even though they seem improbable to us.

Globally, there are many thousands of individuals, money managers and institutions investing in stocks. Based on randomness alone, there’ll be some managers with market-beating results in any given period. But you can’t conclude that skill explains this short-term outperformance. Instead, most managers likely beat the market because they were lucky—and luck isn’t a “strategy” we should expect to persist.

It’s common for investors to favor an actively managed fund if it boasts market-beating three-, five- or 10-year performance. Such results seem to demonstrate that the manager is skilled at picking investments and investors assume this outperformance will continue. But rather than skill, we could be looking at the record of a manager who’s simply been lucky.

Bill Miller of Legg Mason Capital Management’s Value Trust beat the S&P 500 for 15 consecutive years and then flamed out. Was he skilled or lucky? It’s worth remembering that with enough investors picking U.S. stocks, even a 15-year market-beating record may be explained by randomness.

Does this mean there’s no one skilled at stock investing? No. Successful investors like Warren Buffett come to mind. But it takes many years to conclude that an investor is truly skilled. Buffett’s investment record spans decades, so we can be confident that his long-term performance isn’t solely due to luck. Still, he didn’t consistently pick winning stocks throughout his career. No one bats a thousand.

You might opt to buy an actively managed fund to get exposure to a specific asset class if its fees are reasonable and there’s no index-fund alternative available. In doing so, it’s understandable if you take into account the fund’s track record. Just be sure you aren’t considering the fund solely because it performed well recently.

While it’s easy to be a buy-and-hold investor with index funds, you have to keep tabs on actively managed funds to make sure you don’t get stuck with sub-par performance. And if you decide to jettison a poor-performing active fund, what then? Do you go back to square one and pick another actively managed fund with a good record?

The lesson: We can’t be sure that a three-, five- or 10-year record of beating the market means we’ve found a manager who’ll continue to produce superior returns. A manager specializing in, say, small-cap stocks may generate market-beating returns when small-cap stocks are in vogue. But should market sentiment shift to another class of stocks, those market-beating returns will likely evaporate. Such shifts in sentiment seemingly occur at random and are hard to predict.

Occasionally, due to social, cultural or demographic trends, one sector of the economy will outperform the broad market for an extended period. One example is the aging of the U.S. population and the outperformance of health care stocks. Does investing in a growing sector of the economy represent skill? Perhaps—if, say, you invested when those stocks were underperforming and later recognized that those same stocks had become overvalued, prompting you to sell the shares near their peak.

I’d be less inclined to consider it skill if you jumped on the bandwagon after the trend had become apparent. The problem: You may not know when the party is over—and your gains could quickly slip away.

“But wait,” some say. “I’ve picked individual stocks most of my life and I’ve beaten the market. Doesn’t that mean I have stock-picking skills?” Perhaps. But often, people who claim outperformance are focusing exclusively on their winning investments. They may conveniently forget about their stock picks that underperformed and were sold at a loss. Without knowing the degree to which your successful picks outnumbered your unsuccessful ones, and over what time frame, it would be hard to conclude that you have investment skill.

The notion that luck plays a greater role than skill in stock investing bolsters the argument for index-fund investing and broad diversification. The global economy is so dynamic, so subject to geopolitical, cultural, social and natural forces, that prudence dictates we spread our investment bets widely—and not depend too heavily on the stock-picking skills of others.

Be passive, stay diversified, keep costs down, rebalance periodically and stay the course over the long term. That’s how small investors can earn returns that beat many professionals.

Philip Stein, currently retired, was a public health microbiologist and later a computer programmer in the aerospace industry. He maintains that he’s worked with bugs, in one form or another, his entire career. Phil and his wife Jeanne live in Las Vegas. His previous article was Saved by Compounding.

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