Sunday, August 8, 2010

Even a Blind Pig

Even a blind pig finds an acorn every now and then.

Without starting any arguments about free will, predestination, or the permissive will of God, let me observe that both skill and luck play a role in most arenas of life, including investment. There are activities, like chess, that are essentially pure skill. There are activities, like buying lottery tickets, which are pure luck. Most things in life fall somewhere between those extremes. In a excellent article entitled “Untangling Skill and Luck How to Think About Outcomes—Past, Present, and Future” by Michael Mauboussin the author uses statistical analysis to determine the importance of luck in a variety of sports, including the sport of investing.

The author observes, “One point is worth making right upfront: the outcomes of any activity that combine skill and luck will exhibit reversion to the mean. More technically, an extreme outcome (good or bad) will be followed by an outcome that has an expected value closer to the mean. Reversion to the mean is a tricky concept, and the relative contributions of skill and luck shed light on its significance for various activities.”

“There’s a simple and elegant test of whether there is skill in an activity: ask whether you can lose on purpose. If you can’t lose on purpose, or if it’s really hard, luck likely dominates that activity. If it’s easy to lose on purpose, skill is more important.”

What this all means is really very simple. Over time, if an individual’s performance heads towards an expected statistical mean, the activity is dominated by luck. Consider, if playing a particular slot machine is dominated by luck, it would be expected that any individual player would, over time, lose money at the payout rate of that particular casino, say 92%. In the games of poker or bridge even the best players can not overcome a run of truly bad cards, but over time a relative handful of the best players are routinely found sitting at the final table. In football, the outcome of a game can turn on something as unpredictable as the bounce taken by the ball after a punt was blown off course by a wind gust. However, over the course of an entire season, the best teams seem to have the best luck.

There is an interesting quirk in how humans tend to analysis outcome that has nothing to do with mathematics, “But academic studies have found that most people don't fully appreciate the role of chance in their investment results, “We have an asymmetric view of good and bad luck," said Shlomo Benartzi, a business professor at the University of California, Los Angeles. "It's well established that people attribute bad luck to randomness, but then attribute good luck to their own skill.” (The One Missing Investing Ingredient: Luck by Sam Mamudi)

So, if the outcome of individual investing over time tends towards some statistical mean, such as the performance of the Standard & Poor’s 500, what then should we then do?

It turns out the basic answer is pretty simple, consistent investment over time plus compound interest and diversification. If an individual consistently invests 10% to 15% of their income in a balanced and diversified mix of financial sectors and various investment vehicles including stocks, bonds, cash, and foreign currency over the course of 30 years, there is a pretty high chance that individual will be much wealthier than a similar individual who bought lottery tickets, or tried to out smart the market by timing the hot sector de jour. If interested, check out Asset Allocation (Part I and II) found in March and April of this year’s blog achieve. That means a LOW COST! balanced fund such as Vanguard Wellington, plus a bit of precious metals, and some inflation protected securities would likely be a good recommendation for the passive investor.

How about those of us who wish to actively manage our investments, at least to some degree? Again let me quote from the outstanding article by Michael Mauboussin, “In 1984, Warren Buffett gave a speech at Columbia Business School called “The Superinvestors of Graham-and-Doddsville.” 79 He referred to the coin toss metaphor and granted that some investors would succeed by luck. But he went on to point out that a number of successful investors came from the same “small intellectual village that could be called Graham-and-Doddsville.” Common to all of the investors was that they searched “for discrepancies between the value of the business and the price of small pieces of that business.”

Although luck certainly plays a role in investment, men like Buffett and Graham are often found sitting at the championship table as the tournament draws to an end. Let me give a simple example of how this works. The Bank of Nova Scotia (BNS) has turned out to be of my better investments. When I found the stock it was selling for a little over $25 a share then I bought a little more at over $27 a share. I reasoned that BNS:

1)Had been thoroughly pounded by the world banking crisis even though Canada was in better shape than most of the world since its economy is largely based on natural resources.

2)Although there was a housing bubble in places like Vancouver (just beginning to pop by the way) real estate was in better shape in Canada than the US.

3)Canadian banks seem to be better regulated than American Banks.

4)At the time I believed the Canadian Dollar was undervalued and I did not have enough invested in foreign currency.

Today BNS sells for $49 a share and pays a very righteous 3.81% dividend. However, since I bought it at a much lower price, that stock is effectively paying me something like a 7% dividend. Now, if I can just be that smart when it comes time to sell that stock?

In a disciplined approach to technical analysis, a subject for another day, an author recommended keeping a journal detailing the rationale for each investment decision, so that over time the individual could discover what worked and what did not work. I did this during a very brief experiment with technical analysis. I decided I was not cut out for that investment strategy. I think that the discipline of recording and analyzing our financial decision making process might also be good advice for the rest of us if we really want to learn something from Buffet and Graham.

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