Here's How You Can Get Investing All Wrong (A Story About Rock, Paper, Scissors)

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At a recent all-hands meeting at Motley Fool headquarters, we played rock, paper, scissors.

That's right, in our first-floor conference room, 200-plus Fool employees -- investors, techies, editors, administrators, and even Fool co-founders David and Tom Gardner -- engaged in a head-to-head, "only the strongest will survive" rock, paper, scissors showdown. The competition was intense, and a cash prize awaited the winner.

The scene was rambunctious. But before long, the din quieted, the dust settled, and only two combatants remained: Thom Russell and Chris Evans. They'd each won an incredible five straight matches on their way to the final showdown. The room was positively electric as the two spit rounds on their way to one final, sudden-death throw. With bated breath, we all watched as Chris's flat-handed throw of paper bested Thom's close-fisted rock.

Pandemonium.

With cash prize in hand and an unblemished record, Chris was crowned a hero. How was it that he was so good at rock, paper, scissors? Did he have a method? Of course he did! And we all tripped over ourselves to find out what it was.

Anticipating the next companywide rock, paper, scissors showdown, Fool employees bootlegged copies of video footage from the meeting to study Chris' technique. You could hear the whispers around the office as championship hopefuls focused in on the footage. "Did you see what he did with his eyebrow there?" "He went rock, rock, scissors that round and then scissors, paper, rock the next!"

Before long, Chris was magnanimous enough to share his greatness, and he penned an eBook titled "Championship Techniques in Rock, Paper, Scissors: How You Too Can Cut the Paper, Smash the Scissors, and Win Big Cash in Tournament Competition." Motley Fool employees bought so many copies that the book rocketed to No. 1 in Amazon's "Games" category.

As word of Chris's amazing performance made its way outside the walls of Fooldom, the interview requests rolled in. Just days after the win, Chris sat opposite Katie Couric, sharing stories of his scissors-studying childhood and how a diet heavy in sugary cereals and a careful hand-moisturizing regimen aided his rise to the upper echelons of rock, paper, scissors.

There were doubters who questioned Chris's greatness. But they were dealt with easily enough. "Consider his record," his myriad fans would say, "if he wasn't great, how could he have gone completely undefeated for six straight rock, paper, scissors matches?" Further resistance was directed back to the video of Chris's epic championship win. Winners win! What more proof do you need?

This is, of course, a joke. Not all of it -- we did, in fact, have a rock, paper, scissors showdown at Fool HQ, and Chris Evans did win that showdown. But everything after that was a creation of my runaway imagination.

The story should sound familiar to fans of Warren Buffett though. Decades ago, Buffett wrote an essay titled "The Superinvestors of Graham-and-Doddsville." That essay begins with the story of a nationwide coin flipping contest in which a select few coin flippers got fabulously wealthy by "correctly" flipping coins over and over again.

The point -- whether we're considering Warren Buffett's coin-flipping contest or Chris Evans's impressive rock, paper, scissors victory at Fool HQ -- is that luck has a bad habit of masquerading as skill.

Legg Mason's Michael Mauboussin has distilled the skill vs. luck issue nicely, writing:

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.

You'd have to really contort yourself to come up with a reliable way to lose in either a coin-flipping contest or a rock, paper, scissors match. In other words, both activities are matters of luck (sorry, Chris). Even so, if observers were to focus on nothing but the final result, it may appear that the long string of "wins" points to outstanding skill.

It's sadly no different in the world of investing. Investors rabidly chase performance, rushing to whichever asset class, mutual fund manager, or TV guru has exhibited the latest string of wins. Far too seldom does the "skill vs. luck" determination come into their thinking, and the result is that most retail investors end up with returns that underperform basic indexes like the S&P 500.

Picking apart skill and luck can be done. Specifically, the more an investor can understand what process goes into achieving results, the more of an understanding he can come to about whether the results are reproducible or a happy fluke. Sure, it takes more work than simply looking at a results track record, but if your hope is to notch better results than the market average, you should expect to get your hands dirty.

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Read/Post Comments (11) | Recommend This Article (33)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 07, 2013, at 4:25 PM, RussellB6 wrote:

    Baited breath?

  • Report this Comment On September 07, 2013, at 6:23 PM, ChristopherHamel wrote:

    I agree there is a lot of luck regarding paper, rock, scissors, but there are a lot of clues and tells you can pickup on. The mind games and strategy regarding this game are almost limitless.

    Great article and I totally agree, but it Looks like I am claiming I can lose at this game intentionally!

    Coin toss, on the other hand, is pure luck to me as I haven't mastered the torque, height and bounce metrics yet.

    Just kidding there are too many outside variable to ever make coin toss a skill...

    But I do rock at cutting up undefeated PRS champion awards!

  • Report this Comment On September 07, 2013, at 11:15 PM, pstonebridge wrote:

    I'm pretty sure I could come up with a way to lose a lot of money rather quickly on the stock market. That doesn't mean there's no luck involved. Michael Mauboussin's theory only works one way i.e. cannot lose on purpose means lots of luck: but can lose on purpose doesn't mean no luck involved in winning.

  • Report this Comment On September 08, 2013, at 4:48 AM, AnsgarJohn wrote:

    I have made a chart of how well the Superinvestors did after 1984 until 2012. Www.sinaas.blogspot.com

  • Report this Comment On September 09, 2013, at 9:49 AM, Mega wrote:

    "You'd have to really contort yourself to come up with a reliable way to lose in either a coin-flipping contest or a rock, paper, scissors match."

    Not really. If you always throw the same gesture in rock paper scissors, sooner or later your opponents will figure it out and take advantage of it.

    Or if you wait until after the coin flip is done and then pick the wrong side, it's pretty easy to lose.

  • Report this Comment On September 09, 2013, at 10:17 AM, TMFKopp wrote:

    @AnsgarJohn

    "I'm pretty sure I could come up with a way to lose a lot of money rather quickly on the stock market. That doesn't mean there's no luck involved."

    Right. There is luck involved in investing. Just as there's luck involved in tennis too even though that's highly skill based.

    It's a gradient thing, not an on/off. With investing, for example, luck plays less of a part than it does with coin flipping, but more than in chess.

    Matt

  • Report this Comment On September 09, 2013, at 10:19 AM, TMFKopp wrote:

    @MegaShort

    "Not really. If you always throw the same gesture in rock paper scissors, sooner or later your opponents will figure it out and take advantage of it."

    Unless your opponent over-thinks what you're doing and believes the continued throwing of the same thing is your strategy and that you will switch it up at just the right time :)

    Matt

  • Report this Comment On September 09, 2013, at 11:43 AM, SkepikI wrote:

    OK Matt- I assert that investing is ALL Luck. My definition of Luck: "When Preparation meets Opportunity".

    The confusion over "Luck" and random events these days I suspect stems from our everlasting propensity to ascribe things we don't understand, or don't wish to DO to "Luck". That guy was successful by magical means we don't understand (because he did his research and executed) so he's Lucky. The other guy was partly liquid as the market crested in 2007 and created more liquidity because he thought it was crazy, and then invested over time as it tanked, while we were all shaking in our boots....Lucky Snook....

    THE REAL TEST of if something is random or not is an actual statistical method of detecting the randomness or non-randomness of a collection of data in numerical form. Its called Student's T-test. One of my best engineering profs introduced me to it by flipping a coin and challenging us to determine, ACCURATELY if it was a "fair coin" or not. First we guessed based on his flips- they were not very close to 50/50. Then he brought out another coin flipped it and low and behold it was very close to 50/50. We guessed again- the outlier was a rigged coin and the 50/50 was a fair coin. IT TURNED OUT BOTH WERE FAIR COINS, and he proceeded to show us how we could have accurately deduced that with Student's T-test.

    Can you lose intentionally indeed. Goat Entrails, Crystal balls and magic powder matt....

  • Report this Comment On September 09, 2013, at 11:46 AM, coachtom4 wrote:

    I once heard a mathematician say that in order to mathematically prove that a person has skill vs. luck in the stock market would take 80 years, lol... Any mathematicians aren't know for joking around.

    Here is one of my favorites from a couple years ago...

    One of the most famous streaks for mutual fund money managers is Bill Miller’s of Legg Mason Value Trust. His fund outperformed the S&P 500 15 calendar years in a row from 1991 to 2005. Prior to the streak, the fund underperformed the S&P 500 fund 4 out of the 5 previous years by an average of 11% per year. Since the streak ended, the fund has underperformed the index 5 out of the last 6 calendar years by an average of 9% per year. From 1986 to 2011, a 26 year period, the fund outperformed the S&P 500 17 times, i.e. only twice out of the 11 years if you exclude the 15 year streak and underperformed the index by almost 1% per year on average. The question people should ask themselves, was the streak luck or skill?

    Just because you flip heads 15 times in a row does not mean you are skilled at it...

  • Report this Comment On September 09, 2013, at 12:17 PM, awallejr wrote:

    Well what is the old saying? It is better to be lucky than good. Personally I prefer rock, paper, scissors, lizard, Spock.

  • Report this Comment On September 09, 2013, at 2:51 PM, cmrk3 wrote:
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