Investing is simple, but far from easy. And, frankly, sometimes it can be downright frustrating.
Of course, when I talk about "investing," I'm not referring to the generic theme of investing -- that ubiquitous catch-all that captures everything from stashing your money in bonds to rabidly flipping biotech options. Instead, I'm talking about investing in the tradition of Benjamin Graham, Warren Buffett, Seth Klarman, and the host of other value investors that have proven that beating the market isn't a pipe dream.
But let's face it, the investing that involves soberly evaluating how much a company is worth and buying stock in that company when the market price is below your carefully calculated intrinsic value just isn't that exciting. Even if we consider the enormous success of Buffett and Berkshire Hathaway (NYSE:BRK-A)(NYSE:BRK-B), Berkshire's book value has grown on average 20% per year since 1965. Investing veterans likely recognize that as incredible, but it looks like anything but to hot-to-trot traders that are keen to double their money... umm... like, tomorrow.
I recently ran across a blog in which a young, feisty trader shares get-rich-quick trading knowledge with the world. Why would anyone listen to this youngster? Well, as the website tells us, this particular trader is very profitable and makes more than 60% per year.
Take that, Buffett.
That can't be!
I'll admit it, value investors like me have a tendency to get crotchety sometimes. Hearing about someone trading their way to big gains tends to get waived off. "That can't be!" or "You're full of it!" are common reactions.
Well, let me set the record straight: Those big gains may well be 100% true.
Let's run through a quick exercise that's a version of what Buffett put forth in his famous "Superinvestors of Graham and Doddsville" (link opens PDF).
I'm (hypothetically) going to give 1,000 "investors" $100,000. Each gets to flip a coin every month for the next year. Everyone that flips heads gets 20% added to their stack, while those that end up with tails have to give up 50%. Stats students will immediately recognize this as an awful gig -- with a 50% probability of each outcome, the expected value of every flip of the coin is a losing proposition.
That latter point bears out in the numbers when I ran through a simulation of how this game would play out. At the end of 12 months, on average, each of the 1,000 "investors" in the game was left with $15,767 of the starting $100,000. The median value of their stacks was a mere $4,666.
However, among those thousand participants, one of them ended up with a whopping $371,504 in my simulation. That's an impressive 272% gain on the $100,000 starting point over the course of just one year. Freak occurrence? Hardly. Have a coin-flipping contest with enough people and somebody is bound to have a seemingly improbable run of lucky flips.
Maybe it's time for that 272% flipper to start up a blog and tout coin-flipping strategies to the rest of the world.
Results mean nothing!
OK, results do mean something. Especially if you're investing for retirement.
But when it comes to evaluating the merits of an investment strategy or the skill of an investor, judging based solely on the results can be incredibly misleading.
Consider the flip side (no pun intended) to the exercise above. Let's say I tell you that I just lost 20% of my money. That doesn't sound great, and I'd probably have a tough time marketing a hedge fund with that track record. But what if I went on to tell you that I had "invested" $1,000 in the opportunity to grab a jelly bean from a jar of 100 -- 99 of which were blue and entitled me to $100,000 and one of which was red and meant that I'd only get back $800.
My result was unfortunate, but I challenge you to find somebody that wouldn't make that bet.
The point is that anyone with a heartbeat and money to put on the line can make a fortune on a bad bet via blind luck. But others who follow that lucky bloke's lead -- thinking that results equate to skill or wisdom -- can end up dead broke.
Results may be easy to see (and easy to market on), but what's really important for investors is to understand what they're doing, why they're doing it, and why that strategy succeeds.