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Saturday, 1 December 2007

The Role of Luck in Investing

Just as all the children in Lake Wobegone were above average, most investors would like to think that they can achieve above average results - if not now, then in the near future when they have learned the "secret" of successful investing.

In my case I started out buying my first stock investments via a full service broker (in those days there weren't any discount brokers and the Internet wasn't invented yet), generally picking one or two based on avid reading of the stock tips provided in the brokers in house "research" newsletters. After a while I noticed that the broker only seemed to advise stocks to buy and wasn't very good at telling you when to sell a stock (many years later I learned that a "hold" or "underperform" recommendation was code to get out of a stock, and that brokers had a vested interest in giving mostly buy recommendations), so I paid for a subscription to an investor newsletter that advertised impressive returns in recent years. After a while I realised that it was impossible for a small investor to follow all the trades recommended in the newsletter, so you were back to flying solo in terms of picking a few of the recommended stocks. It also turned out that "past performance is not a reliable indicator of future returns" - many newsletters attract subscribers based on a run of good "stock picks" but then fade away when their future selections fail to perform.

The next step as an investor was to read widely and try to learn how to sort the wheat from the chaff for myself. This leads one to fundamental analysis (such as p/e rations, debt ratios, book value and so on), through value investing (looking for good stocks that can be bought for a good price due to being temporarily out of favour), momentum investing (the trend is your friend), contrarian investing (the herd tends to overreact) and variations such as the zulu principle (high peg stocks), technical analysis (charting), and so forth. Some investors will fall in love with one of these approaches, generally because they have some luck with one method or another. While some investors may have the ability, skills and dedication to succeed at one of these approaches, there is great danger that one confuses luck with skill and will continue to pursue a particular strategy when it no longer works. It also turns out that what you read in company reports often isn't all that helpful. Apart from the standard ploys of including graphs of recent annual results if profits and marketshare are increasing, and using tables (or no previous results) and concentrating on "vision" statements when things aren't going so well, the financial figures can be manipulated in many interesting ways. While you may be able to discern the true situation by sifting through all the footnotes to the accounts, it can sometimes be impossible to identify when "creative accounting" is being employed.

Not knowing which, if any, investment approach will work I eventually came to adopt the semi-strong efficient market theory (with some reservations as to it's real world application in times of irrational exuberance or "the madness of crowds"). I tend now to invest with a core of index funds and only the occasional punt on a particular stock that I feel may outperform. Theoretically having a diversified portfolio of 20-30 stocks should eliminate a large amount of the risk associated with attempting to pick individual "winners" and leave you with close to market levels of risk (volatility). However, a recent article by Marcus Padley shows that luck still plays a huge role in how your stock portfolio will perform if you invest in a selection of twenty or so stocks. For example, if your portfolio of 10-20 Australian stocks picked from the ASX200 had happened to exclude BHP Billiton, this year your returns are likely to have been only 7.6% rather than the 13.85% achieved by the ASX200. In fact, excluding the top 10% (the best performing 20 stocks in the ASX200), the return of the remaining 180 stocks was -0.4%! The 20 best-performing stocks in the ASX 200 have averaged a rise of 146 per cent this year, while the 20 bottom-performing stocks have fallen an average of 36 per cent. So in any group of individual investors that pick a handful of stocks for their portfolio out of the ASX200 you would get some that do very, very well and some that do extremely poorly just by pure luck.

Copyright Enough Wealth 2007

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