This is the second in a series of essays about why investing is difficult to learn. To read the first installment, click here.
2. It is difficult to distinguish the contributions of skill vs. luck.
Imagine that you bought Google stock on December 31, 2011 at a price of $645.90. As of mid-December, the stock is at about 720. This is an increase of about 11.5% in a little less than a year. Was this a good decision? How much of the decision should be attributed to skill vs. luck?
First, we should determine whether it was a good decision. At a first glance, earning over 11.5% per year sounds pretty good. But one needs to consider how the entire stock market did during that same period. Could you have bought a random stock or group of stocks and achieve a similar or better result? If you had instead bought the Vanguard Total U.S. Stock Market ETF (VTI), you would have purchased it at a price of 63.39 and in mid-December, its price was around 74. This is a 16.5% increase. So, even though the appreciation of Google stock was quite good from an absolute standpoint, it was not very good when judged relatively against the whole stock market. Buying a random stock would have more likely than not outperformed Google. The outcome of the Google purchase decision was favorable when compared to doing nothing, but the decision to buy Google instead of a broad-based fund demonstrated either lack of skill to choose a better-performing stock than the average or bad luck in choosing a stock at random.
Judging skill based on a single decision is extremely shortsighted. Skill can only be determined after a long series of decisions made at different times, under a wide variety of market conditions. Warren Buffett is acknowledged as a skillful investor because of many decisions he has made for decades, not just because of several fortuitous stock purchases made in a single year.
Luck plays a much larger role than many finance professionals would like to admit. Because of this significant luck component, an investing novice can achieve reasonable results without knowing anything about investing. Contrast this characteristic with other skill-based disciplines, in which a beginner is the worst performer. The person who is just beginning to learn how to play a musical instrument does not compare well with those who have more experience. The novice at most physical sports will lose to those who have more practice. Luck plays a minor role in such endeavors. Now consider a game, such as roulette, in which luck solely determines the outcome and skill is not involved at all. A first time player will win at roulette about as much as the player who has been playing his whole life.
Investing is somewhere in between the extremes of being based on 100% skill and 100% luck. Exactly where, no one knows. It is like the game of poker or bridge: there are components of both luck and skill. If you make just a few decisions, luck will have a strong influence on your results. If you make a lot of decisions, the skill of your decision-making process will determine your relative success as effects of good luck will tend to cancel out those of bad luck over the long run. Just as a skillful poker or bridge player could lose a hand or two to a lucky beginner, if the game is played long enough, the luck of the draw will tend to even out, and the skill of the better players will lead them to more wins than losses.
Since investing is an activity that typically lasts a lifetime, skill matters a lot. After many years of making investment decisions, the relative contributions of luck vs. skill will emerge if you take the time and effort to carefully evaluate the quality of decision-making. However, there are obstacles to getting a truthful, unbiased evaluation of your skill level, because it is difficult to maintain objectivity when making judgments about your own investing skill. That is the topic of the next essay in this series.
Cognitive Investing 