In part one of this series, we examined whether investing is a game. If you have not read that essay (https://cognitiveinvesting.com/2011/11/17/is-investing-a-game/#more-216), I suggest reading that first. In part two of this series we examined the question of whether investing is a negative-, zero-, or positive-sum game? I encourage you to read that essay (https://cognitiveinvesting.com/2011/12/14/is-investing-a-game-part-2/#more-231) also. The question we now turn to is whether investing is a game of luck or skill. How much is luck and how much is skill?
If I buy a stock and after a year it is higher, is that due to skill or luck? If it is lower, is it due to bad luck or lack of skill? One of the most common answers is to attribute all good outcomes to skill and poor outcomes to luck. That way our egos stay intact. It also saves us from having to make a true assessment of whether we are truly skilled at choosing investments.
But to get to the truth of the matter we need to risk deflating our ego and determine whether our decisions really are better or worse than average. Beating the average is very relevant in a zero-sum game and even more so in a slightly negative-sum game, which is what the stock trading game is after commissions are taken into account. Since the long-term holding of stocks is a positive-sum game, that part of the equation must be removed to figure out if we are making better short-term decisions than other investors.
Let’s return to the example of a stock that is purchased on some random date and is higher one year later. Since stocks, on average, increase by about 8-10% per year, we should expect that sort of return without any special skills. To demonstrate skill, the stock would need to go up higher than the average. A stock that only went up by 5% would appear to be a good decision, but relative to the average it would be an inferior decision.
The next issue is that making a judgment after only one event is extremely shortsighted. This would be like judging the quality of a football team after one play. In order to make an intelligent assessment, many samples are needed. In the stock picking game, the time period should include periods of rising, falling, and sideways markets. If any one of these types of markets is omitted from the sample set, conclusions are likely to be suspect. For example, if I buy nothing but emerging market stocks and the time period is one of primarily rising prices, I might look brilliant. My stock picks will likely outpace broader market averages. However, this is really more due to the fact that emerging market stocks typically rise more in bull markets and fall more in bear markets than stocks in general. The decision wasn’t really very brilliant; I was just lucky and the measurement period was not representative of the whole environment.
How many decisions does it take to be statistically significant? And over how long a time period? Although the answers to these key questions are debatable, I would venture to say that at least a hundred decisions are required to make a reasonable assessment, and the time period should be measured in years, and not days, months, or quarters. The last two major stock market tops occurred in 2000 and 2007, and the major market bottoms occurred in 2002 and 2009. Thus the cycles were, on average, about seven years long. The next cycle is undoubtedly not going to be exactly seven years, since markets never fall into such a predictable pattern. But seven years is a suitable time frame for making judgments about anyone’s ability to choose stocks. The number of decisions turns out to be less of an issue, if one includes a suitably long time frame. The reason is that not doing anything is a decision, so even if someone made one transaction in seven years, he would also be deciding (consciously or not) to not make thousands of other potential transactions along the way. So the number of decisions takes care of itself as long as the time frame is long enough.
So let’s say that we measure our performance for the last seven years and our investments have appreciated at an annualized rate of 8% per year. Did our choices add or subtract value? Or to put it another way, were we a winner or loser in the negative-sum game? We need a basis for comparison. We can compare our performance against a published benchmark like the S&P 500 index or the Russell 2000 index, but those indexes are not purchasable. A more valid comparison is a decision we could have made, which would be to buy an index fund of some sort that tracked one of those indexes. These funds incur real-world expenses and are thus more of a true alternative.
If our goal is to have a well-diversified portfolio, we should compare that to a broader set of comparable funds in appropriate proportions. As a simple example, let’s say my target was to own 60% stocks and 40% bonds. I should compare my real performance to a benchmark portfolio that owns 60% of a purchasable fund that tracks a suitable stock index and 40% of a similar bond index fund. If my performance does not exceed the total performance of this group of funds, then I am on the losing side of the negative-sum game. If I exceed that level of performance, I am on the winning side.
But what if we don’t measure our performance, or compare it to an appropriate benchmark? First, we will have lots of company. In my experience, most self-directed individual investors do not accurately measure the quality of their decision-making by comparing their performance to a passive alternative. Granted, the calculation can get complex, since intermediate cash flows in and out of the portfolio confuse things. Aggregating all accounts can be laborious. However, measuring one’s performance with absolute precision is not as important as getting a close approximation. Most individual investors don’t even try to do this. But it is necessary if we are to determine our skill level.
If you think the game is just luck, then measuring your performance is a waste of time. Many investors subconsciously invest as if it is just a casino and their results are due to chance. And you can invest according to this underlying assumption if you wish. Throw darts at a stock page. Throw darts at a calendar to tell you when to buy or sell. If you do this randomly and often enough, you might not do too poorly, since you will likely come close to an average performance. But I don’t think this is a proper way to treat your life’s savings and accumulated wealth.
By not accurately measuring our performance, we can pretend that we are one of the winners when we are really one of the losers. Our ego stays intact. We are saved from the embarrassment of realizing that our efforts to add value have actually subtracted it instead. We don’t have to ask fundamental questions or change anything about our whole process of investment decision-making. And best of all for the winners of the game, we provide them with profits.
Even though the majority of investors think they are winners at this negative-sum game, the truth is that there are more losers than winners. Thus a fair number of losers are under the illusion that they are winning. This certainly applies to professional mutual fund managers. Countless academic studies have demonstrated that significantly less than half of all actively-managed mutual fund managers beat their benchmark after expenses. These managers are extremely intelligent, have many more resources than most individual investors and yet, in aggregate, they don’t win, simply because they are playing a negative-sum game.
A rational decision-maker would come to the conclusion that accepting the “default” decision of buying several index funds in appropriate proportions for their individual circumstance is a far better choice than to try to be in the minority of winners in a negative-sum game played by professionals who have vastly more time and resources to devote to the game. By taking the default path, the cognitive investor wins the game by not playing.
Many self-directed investors are gradually figuring this out. The percentage of assets in index funds has steadily grown each year for at least the last 10 to 15 years. Another way some of the losers have left the game is to sell out of stocks entirely. There is ample evidence of this trend: mutual fund investors have been net sellers of stocks for most of the time since 2008. As many of the former losers stop playing the negative-sum game of short-term stock trading, it makes it that much more difficult for the winners, since the “chumps” have left the poker table. Unless you can identify the loser at the table, you should not be playing this negative-sum game.
What about having someone else who is more skilled play the game on your behalf? That is the topic of the next installment of this series, “Is investing a game?”