FOOL ON THE HILL
Is Investing Success Just Luck?

Some academics argue that a randomly selected portfolio of stocks will perform just as well as a portfolio carefully selected by market professionals, and there is research to back up this claim. Thanks to the interplay of randomness in the stock market, investors face an uphill climb predicting earnings and picking winning stocks. It's a good thing we have index funds.

Format for Printing

Format for printing

Request Reprints

Reuse/Reprint

By Richard McCaffery (TMF Gibson)
November 30, 2000

We spend a lot of time talking about competitive advantages and quality businesses, which is another way of saying we think the average investor, with diligence and patience, can become a pretty good stock picker.

So, how come we read statements like the following from educated sources:

"When people buy stocks, they think they are playing a game of skill," said Meir Statman, finance professor at Santa Clara University in California. "When the stock goes down rather than up, they think they have lost their knack. But they should take heart. All they have lost is luck. And next time, when the stock goes up, they should remember that was luck too." (From a September 26 Wall Street Journal article called "Don't Ignore Luck's Role in Stock Picks.")

I thought Statman was crazy when I read that story.

How about this from Burton Malkiel, economics professor at Princeton University and author of A Random Walk Down Wall Street: "The academic community has rendered its judgement. Fundamental analysis is no better than technical analysis in enabling investors to capture above-average returns."

You have to be kidding.

Malkiel bases this statement on the miserable performance of most actively managed mutual funds over a long period of time; on academic tests that demonstrate analysts can't predict earnings for five years or even one year with any kind of accuracy -- even in so-called predictable industries such as utilities; and on the brutal interplay of randomness of events in the business world.

For example, Malkiel looks at changes in the staid utilities industry that affected earnings over the last three decades. In the 1970s, higher oil prices impacted profitability. In the 1980s, the Three Mile Island incident shook the nuclear power plant sector to the bones. In the 1990s, deregulation and competition took a bite out of margins.

Analysts failed to predict these random events (that's why they're random) and earnings for many companies suffered. Malkiel's point is that random events are an intricate part of life in the business world, and these events make it very difficult for investors, whether professionals or not, to predict earnings and find winning investments.

Say it ain't so.

What about the handful of investors who gamely outperformed the market over the long haul -- Bill Miller of Legg Mason, former Fidelity Magellan Fund manager Peter Lynch, and Berkshire Hathaway (NYSE: BRK.A) Chairman Warren Buffett. Please don't tell me this kind of success can be written off as luck.

"The very small numbers of really good performers we find in the investment management business actually is not at all inconsistent with the laws of chance," Malkiel wrote.

This might sound ridiculous, and I think you could argue that, statistically, the chances of anyone beating the market for as long as Buffett, Sequoia's Bill Ruane, or former Windsor fund manager John Neff did, are small enough that their success can't be written off as chance. That kind of performance is statistically significant.

But, talking to Paul Commins (TMF Buster), reading Malkiel's Random Walk, and John Allen Paulos' Innumeracy have given me a respect for randomness, probability, and luck that I completely lacked.

For example, Paulos tells us there's always enough random success to justify almost anything if you want to believe it. I'm going to remember this the next time I pick a stock that soars (heck, I'm still waiting for the first time), or read an investment newsletter promising market-crushing returns. A lunatic could crush the market any given year -- that doesn't mean he has any special stock-picking skills.

Random success isn't at all unlikely. On the contrary, the laws of chance and randomness dictate that successes will occur all the time -- just in places we can't predict. Are you a person who oohs and aahs when unlikely events occur? Paulos tells us unlikely events occur all the time. What would really be surprising is if unlikely events didn't occur. How many people do you have to put in a room before there's a 50% chance two will share a birthday? Just 23, a lot fewer than I would have thought.

(By the way, National Public Radio interviewed Paulos about the presidential election last week and he said more in 30 seconds than pundits have said since November 7. Don't believe the Florida recount is truly a search for the will of the people. The margin of victory was smaller than the margin of error. In other words, the tools being used to measure the results aren't sensitive enough to make an accurate determination. We could count and recount and come up with a different answer every time. The election was a tie. Want a fair result? Flip a coin. And, for the love of Pete, let's computerize the voting process.)

Malkiel writes, "No scientific evidence has yet been assembled to indicate that investment performance of professionally managed portfolios as a group have been any better than that of randomly selected portfolios." Considering the time, effort, and money poured into beating the market, and even weighing the short-term mentality of most mutual funds, I find that statement remarkable.

Now, much like Malkiel, I think academics go too far. I don't believe stocks are always efficiently priced, and investors who focus on fundamentals have a better chance of capitalizing on inefficiencies than others. But, I'm now convinced that money managers with the skills of Lynch and Buffett are rare birds and that, for myself anyway, the bulk of my investing returns will probably come from a good old-fashioned index fund, where the proceeds roll up and down with the market and the forces of compound interest and tax-deferred growth grind out gains year after year.

I won't stop trying to improve my investment skills. I get a lot of satisfaction studying businesses, and I'm hoping to find a few gems in a lifetime of investing. I also believe taking a commonsense view will give me an edge. The strategy is pretty simple: Hunt for high-quality companies with solid fundamentals that trade at reasonable prices; look for businesses I understand and admire; and invest for the long term.

Picking up this kit of tools and using it to find successful investments, however, where there's so much room for subjectivity, randomness, and other influences, is no cake-walk. I'm beginning to understand this. If my picks go up, I'll understand luck played a big role -- that random events unfolded in my favor.

And, I don't think Meir Statman is crazy anymore.