Meet the World’s Luckiest Investor

Photo source: Umberto Salvagnin

Meet the world's luckiest investor. His name is Richard. You've probably never heard of him.

Richard has compounded money at 24.55% annualized for the last 30 years, compared to 9.4% for the S&P 500 (SNPINDEX: ^GSPC  ) . That difference is staggering. One dollar invested with Richard 30 years ago would be worth $712 today, versus $15.30 if you invested in the S&P 500. He's only had three down years. Richard has actually outperformed Warren Buffett's Berkshire Hathaway over the past three decades.

Why have you never heard of Richard? Well, his name isn't actually Richard. As far as I know, at least.

Richard is the winner of an Excel model I made that generated random investment returns for 65,000 hypothetical investors during the last 30 years. (The model was guided by the boundaries of the market's actual historic returns.) 

Let me reiterate: Richard's results are achieved from sheer randomness, the equivalent of throwing darts at a board, or pulling bingo balls out of a cage. 

Richard is alive because of a simple law of probability: If you conduct enough experiments, you'll get a few crazy results, thanks to pure randomness. I named our hypothetical world's luckiest investor after Richard Lustig, the real-life man who has won the lottery seven times.

There are millions of investors in the world. Many of them are actively trading in and out of stocks, picking what they think are the best investments. With that many investors, we are virtually guaranteed that a few of them -- but just a few -- will be hugely successful over time due to nothing more than random chance.

Richard almost certainly exists somewhere. Some of the world's most successful investors are actually just some of the world's luckiest investors. I don't know what Richard's real name is. Maybe it's George Soros, or Peter Lynch, or John Paulson, or David Tepper. We'll never know for sure. 

What do you do in this situation? How do you know which investor to follow, to idolize, to learn from, in a world where it's hard to tell who has been successful and who has been lucky?

The key to identifying talent versus luck comes down to understanding the difference between process and outcome. As Barry Ritholtz put it last week:

Outcome is simply the final score: Who won the game; what numbers came up in a roll of the dice; how high did a stock go. Outcome is the result, regardless of the method used to achieve it. It is not controllable. You can blow on the dice all you want, but whether they come up "seven" is still a function of random luck.

Process, on the other hand, is a specific methodology. It is a repeatable approach to any challenge or endeavor, be it construction or medicine or investing. And you can control a process.

Buffett made this point decades ago in a speech called, "The Superinvestors of Graham and Doddsville." Say we set up a national coin-flipping contest. By sheer chance, more than 200 people in the country will correctly call 20 coin flips in a row. Even if the coin flips were done by orangutans, Buffett pointed out, this is what you'd expect.

But what if you found out that of those 200 successful orangutan coin-flippers, half came from the same zoo in Nebraska? Then you'd realize what was going on was more than random chance. Buffett stated:

I think you will find that a disproportionate number of successful coin-flippers in the investment world came from a very small intellectual village that could be called Graham-and-Doddsville. A concentration of winners that simply cannot be explained by chance can be traced to this particular intellectual village.

That intellectual village was value investing, influenced by Ben Graham and David Dodd.

What made value investors legitimate success stories was not just their superior returns. It was their rational process of buying companies with high returns on capital for less than liquidation value and holding them for longer than most investors were willing to.

Your definition of a rational investment process may be different than mine. But when I hear of investors successfully predicting a market crash by overlaying a chart from the 1920s, or day trading penny stocks, or using a protractor on a candlestick stock chart, I get suspicious. When you find yourself asking, "How can they make that much money doing that?," remember Richard. 

Not realizing the difference between luck and skill puts you on a road to ruin. When returns are the result of luck, the person who earned them is going to assume whatever absurd technique he or she used is pure skill, and is likely to keep using that technique with a false sense of confidence. That's dangerous, because luck quickly reverts to the mean -- if I kept my Excel model running long enough, Richard will eventually come crashing back to Earth.

That's why process matters so much more than outcome. Investors shouldn't just focus on returns. What you want is a rational process that offers the highest chances of success over long periods of time without relying on luck. Earning a lower return than your lucky friend Richard shouldn't bother you if he's flipping a coin or day trading penny stocks. Your rational investing process is far more likely to win out in the long run.

"We have no control over outcomes, but we can control the process," Michael Mauboussin once wrote. "Of course, outcomes matter, but by focusing our attention on process, we maximize our chances of good outcomes." 

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics. 

 


Read/Post Comments (9) | Recommend This Article (39)

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  • Report this Comment On March 03, 2014, at 10:35 AM, Mathman6577 wrote:

    Richard is probably at the extreme right edge of the probability density distribution which is most likely lognormal with a sigma close to 1. Most investors perform well below the mean of compounded rate of return and a few perform well above the mean. Richard, Buffett, Soros, and Lynch (who was probably the highest in history) are among the few that are at extreme right tail. We shouldn't be following them but instead follow the > 99.9999% that lie well below them towards the mean (and below) and learn from their mistakes (instead of the successes of the few).

  • Report this Comment On March 03, 2014, at 2:02 PM, dmc99111 wrote:

    I was wondering how many iterations of the excel program you ran before you found Richard? 24.55% for 30 years seems excessively coincidental for just one run of the program.

  • Report this Comment On March 03, 2014, at 2:13 PM, TMFHousel wrote:

    dmc, thanks for the question. I ran it roughly 300 times, which generates results for 19.5 million hypothetical investors. Each iteration generates a winner far above the average 9% return of the market, but I had to hit F9 many times before I found Richard. I'd send you the spreadsheet but it's too large for email (I can barely keep it open without it crashing).

    -Morgan

  • Report this Comment On March 04, 2014, at 9:16 PM, SkepikI wrote:

    ^ ahhh Morgan, hilarious... so if I interpret this correctly, and incorporate mathman's analysis, you only would have had to destroy somewhere between 300 and um half of 19.5 million lives call it 10 million in round numbers to become Richard.....

    Thanks for the statistical pot of gold, but I will stick to being just a bit over the market average...achievable by mostly index investing and puttering about the edges...or perhaps more bluntly risking disaster with only a little randomly.

    BUT food for thought and perhaps humility for those of us who are not totally random

  • Report this Comment On March 05, 2014, at 9:25 AM, slpmn wrote:

    Thanks for discussing an important issue that investors should understand. You nail it with your statement that "Not realizing the difference between luck and skill puts you on a road to ruin." So, focus on sound, proven tools of fundamental analysis and you'll do OK in the long run. And, ignore the guy in the cube next to you who seems to hit nothing but home runs with obscure stocks he picks out of the air. Unfortunately, it will come around for him.

    But the other thing that I think is worth pointing out is that there's too much hero worship in investing. Warren Buffett is a Richard. Brilliant, yes, applies rock solid investment philosophy, highly disciplined, all of that, but he is the outlier. He's the monkey who flipped heads 200 times. There are a thousand brilliant investors doing the same thing he's doing, but their returns will be much closer to the mean, simply because there is a random element to investment returns. And if there's a random element, that means a tiny fraction of game players will roll sixes all the time. It's just math. That's Warren. He can't see the future. He can't control what happens to the companies he invests. But it has all worked out for him.

    I work with banks and I had a client like that several years ago. His bank was pristine. Flawless. They didn't have a charge-off for more than five years. Zero. That's unheard of. Never had a bad loan, all while growing aggressively and making buckets of money, which means they weren't only taking the risk-free borrowers. I asked him how they did it, and he said simply, "We don't make bad loans." Uh, OK.

    Well, looking back, I really think he was just lucky. A really sharp guy and a really good banker, with really good people, yes. But that can't explain it. They couldn't control what happened after they made the loans. Borrowers get divorced, their businesses suffer rough patches, happens all the time. Didn't happen to this guy's customers. So, I think he was lucky. To wrap it up, he sold his bank in 2007 for one of the highest multiples I had seen in the region. And in 2008, the banking sector fell off a cliff. Luck.

  • Report this Comment On March 06, 2014, at 8:14 AM, bamasaba wrote:

    Never confuse luck with skill. Never confuse skill with insider trading.

  • Report this Comment On March 06, 2014, at 4:43 PM, toastedseeds wrote:

    In poker it's called being "results oriented". 72 off suit has a 20% chance against AA. Which would you rather play?

    ts

  • Report this Comment On March 06, 2014, at 7:39 PM, slotowner wrote:

    There is also the other tail which people should not forget. You can have a good strategy, make smart choices, follow a strict plan, & still crash & burn.

    It is one of the reasons you should always have a worst case scenario (although it CAN still get worse than that). I've see to many with good plans & ideas who planned it too fine & could no outlast a bad streak.

    As they say in Vegas, the house can afford all of your good streaks but your bad streak ends when you get to zero.

  • Report this Comment On March 07, 2014, at 2:45 PM, 092326 wrote:

    Investing is like a cancer, feed it money properly and it continues to grow.

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