This month’s issue features a discussion about how to differentiate between luck and skill. It is a topic Michael Mauboussin of Credit Suisse covered in his book “The Success Equation” (Harvard Business Review Press, 2012). When we spoke, Michael opined that skill plays a role if you can affect the outcome. A transcript of our conversation starts here.
Michael thinks investing falls pretty far over to the luck side of the luck-skill continuum. I agree that there is a great deal of luck involved, since we investors have no control over the economy, the management decisions made by the companies we invest in, earnings, analyst ratings, what fund managers do or how all other investors and traders act. Much of what moves prices is the reaction to and the anticipation of new information. This is why some experts, such as the economist Burton Malkiel, say the movement of stocks is a “random walk.”
On the other hand, there are steps I think an investor can do to maximize his return given the level of risk he is willing to tolerate. Learning how to analyze securities and funds, diversifying, adhering to what has worked well over the long term and avoiding behavioral errors will lead to comparatively better outcomes. By focusing on these things, an investor can create “luck” for his portfolio.
Part of my view toward creating luck comes from playing poker. Though admittedly not a perfect analogy, poker is a game of statistical probabilities where skill can have a small but measurable impact. A player who focuses on playing good hands (e.g., a pair of aces) and quickly folding bad hands (e.g., a three and an eight card of different suits) should win more often than a player who ignores the odds. Process, in both poker and investing, is important.
When money is being lost, it does become tougher to stick to a good process. However, not sticking to a good process compounds the impact of bad luck. This is why you may have noticed more articles about the mental and emotional aspects of investing. Starting this month, you’ll now be able to locate these types of articles on AAII.com under the new category of “Behavioral Finance.”
Bad luck can also be compounded by making investment decisions based on perception instead of facts. I refute several common investing myths in my latest Beginning Investor column here.
One of the myths I debunk is that growth beats value. Stocks with low price-earnings ratios have historically realized higher returns than stocks with high price-earnings ratios. Not all stocks with low price-earnings ratios are bargains, however, so you do need to consider why a stock seems cheaply or expensively valued. Joe Lan explains how in his latest Financial Statement Analysis article here.
As I mentioned above, I think diversification is one of the keys to creating luck for your portfolio. Not only does diversification increase the odds of being in the right asset class at the right time, it can also reduce your portfolio’s risk. This is accomplished by holding assets with low correlations to one another—meaning they have different return characteristics. Richard Bernstein, who advises two asset allocation funds, spoke to me about how to successfully achieve proper diversification. You can see a transcript of our conversation and a chart of current correlations here.
Our third annual list of the exchange-traded funds (here.with the best three-year performance also shows the importance of diversification. Only one fund has made the top-10 list for all three years. You can see the current top performers
Finally, if the uncertainty of the market worries you, annuities can be an alternative since they guarantee a minimal level of cash flow. Annuity contracts can be complex, however, so you should understand all of the associated costs before investing in one. Stan “The Annuity Man” Haithcock gives great guidance on what to look out for starting here.
Wishing you prosperity,
Charles Rotblut, CFA
Editor, AAII Journal