Luck, or Skill?

Let's consider two investors.

Investor A buys shares in XYZ Corp., confident that the company is undervalued. He or she invests in the business, and shortly afterwards, the stock drops by as much as 50%. For well over a year, the stock price remains dormant. All the while, the investor sees share prices rising at other businesses he or she's familiar with. Investor A reassesses the situation and does nothing.

Investor B, also favorable on XYZ Corp., begins buying shares a year later at about one-half of Investor A's cost basis. The following year, Mr. Market catches up with XYZ, and the stock doubles. Investor A is back to even, and Investor B is sitting on a 100% gain.

Which investor would you rather be? With hindsight, it seems that Investor B looks rather smart and savvy, while Investor A just got unlucky buying at the wrong price or the wrong time. Actually, the situation should be viewed from a totally different perspective.

Introducing Investor A
What if I told you that Investor A was, at one point, Warren Buffett? In 1973, it was. At that time, Buffett began buying shares in Washington Post (NYSE: WPO) for his company, Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B). Based on a historical stock chart in The Warren Buffett Way by Robert Hagstrom, shares in the Post declined after Buffett's purchase, and it took more than a year for the company's stock price to surpass Buffett's purchase price. While shares did not decline by the hypothetical 50% from above, they were down more than 20%, and Buffett had to wait.

Understanding skill and luck
Regardless, Buffett is just an example of the bigger picture for investors. All too often, the terms lucky and skill are tossed around the investment field inaccurately. The truth is that investment skill will always lead to certain moments of luck, but in the long term, luck simply can not last long enough to produce a consistent, profitable result.

The Investor Bs of the world are often looked at as more skillful than the Investor As. That's a misguided view. In this case, both classes of investors have skill. The point to understand is that very few investors will ever buy at the bottom. Investor B, while a skillful, prudent investor, merely got lucky by purchasing a security at the bottom. Investor B realizes this and understands that in the future, he or she will miss the bottom more often than not. In both instances, he or she is investing based on intrinsic value assessments and not on market volatility.

Investor A also realizes that he or she is no less skillful an investor because Mr. Market has suddenly decided that the business is "worth" half of what Investor A paid. In fact, Investor A welcomes the decline because it offers an even better bargain investment. Again, the investment is made solely on the basis of intrinsic value, not Mr. Market's value.

Today's Investor A
Right know, some very smart names like Eddie Lampert and Michael Price are sitting on huge paper losses from some of their recent investments, namely Citigroup (NYSE: C) for Lampert and Sallie Mae (NYSE: SLM) for Price. It's quite obvious that a lot of intelligent investors underestimated the severity of the credit crunch. Most investors are quick to admit that if they knew then what they know now, they might have done things a little differently. Nonetheless, guys like Lampert and Price didn't get where they are by making the wrong bet too often. And I doubt that they are losing sleep because the market prices of their investments are significantly lower.

Lampert's own company, Sears Holdings (Nasdaq: SHLD), is down nearly 50% from its highest price ever. By most accounts, the current price of Sears is giving you Lampert's investment ability for free. The problem is that Mr. Market is very sour on retailers because of the difficulties that exist in that industry now. I doubt that most investors who bought Sears at higher prices, if they did their homework, are concerned.

Sit still
English author A.A. Milne once remarked, "The third-rate mind is only happy when it is thinking with the majority. The second-rate mind is only happy when it is thinking with the minority. The first-rate mind is only happy when it is thinking."

As usual, there are multitudes of opinions concerning the stock market, and if you focus only on your data and reasoning, you will be right more often than you are wrong. More than a year went by before Buffett's stake in Washington Post increased in value. Thirty-five years later, his $10 million investment is worth more than $1 billion. Therefore, invest and think, wisely, Fool.

Further Foolishness:

• The Death of Berkshire Hathaway?
• Buffett Bets on The U.S.