How to distinguish between true investment skill and luck
Even if an investor has obtained superior results over an extended period, is this sufficient proof that these investment results were actually due to skill rather than just a lucky streak?
No, these investment results could still be due to chance. For example, take a large population, such as all individual investors in the U.S., and have each person perform a random chance operation like flipping a coin repeatedly. After many repetitions, a small portion of the population could appear to have remarkable results.
After 10 consecutive coin flips, some investors probably would have flipped 10 heads in a row (HHHHHHHHHH). If each head were to indicate a consecutive win in the stock market, that person might seem like an investment genius. However, ten heads in a row is no more or less likely than any other particular sequence of heads and tails. The person who flipped THTTHTTHHH has a sequence that is just as unique as 10 heads in a row. The person who flipped THTTHHTHHH, which is different only on the sixth coin toss, also has an equally unique sequence. However, to many people, these sequences of heads and tails would not appear to be nearly as exceptional as 10 heads in a row, even though the really are.
Repeated investment success may still be the result of luck rather than skill.
While it may appear that the person who got 10 heads in a row did something remarkable, it just appears to be more unusual, because the results were all the same. In a similar vein, if a large population of investors were each to choose investment securities at random and were to do this repeatedly, the results will be purely accidental. However, those who happened to pick securities with better results might seem like geniuses.
Given human propensities, you could almost guarantee that the longer the sequence of their accidental winners, the more the chests of these lucky winners would inflate with pride. They would probably also become increasingly vocal. The fact that they are no more or less likely to be a winner in the next round than any other participant, might be lost on them and anyone who hears their story, until the results of the next round are known. In addition, even if they lose the next round, they may conveniently not report their loss. Too many lucky throws of the investment dice and these persons could be absolutely insufferable at cocktail parties. (See: Can you really beat the securities markets? and Chance creates the illusion that investors can beat the stock market)
Only if an investor makes numerous specific predictions over time about WHY the prices of various securities will move in particular directions and those predictions come true far more often than not, can investment skill rather than dumb luck be demonstrated.
Because long-term success may still be due to random chance, there needs to be more stringent criteria for judging true investment skill. True skill might be demonstrated by two methods:
- An investor with superior skill could have a better understanding of what known information means and could use trading strategies to capitalize upon that better understanding. For example, such an investor might be better at using published accounting information to identify companies whose default risks would in fact turn out to be different from what others judge them to be. If such an investor made a large majority of such accurate selections, then it would be more probable that this analyst demonstrated superior skill.
- An investor with superior skill might be a better prognosticator of what is likely to happen in the future. In this case, the investor would make specific prior predictions about things that would happen. A higher degree of accuracy on specific predictions would be a way to identify an investor with skill.
Both of these potential sources of verifiable skill have a common element, which is the specificity of their predictions. Not only must an investor with skill call the direction of price movements, he must also predict why the price will move with a reasonably high degree of factual precision. If an investor predicts that a security will perform exceptionally well for specific reasons, and it does perform well, but for reasons that have nothing to do with his predictions, then this is still a chance result and not skill. (See: The illusion of superior professional investment manager performance)
The future unfolds unpredictably, and just because it turns out one way or another does not make an individual investor a genius or a fool.
An investor can only properly claim to be an investment genius when the proof is indisputable over a very long history of precise predictions of what would happen. Moreover, as with soothsayers and charlatans, it does not count to predict accurately a few times in the midst of a very large number of inaccurate predictions. Certain investors have received substantial acclaim because they once accurately called and acted upon a turn in the market, while their other erroneous predictions were forgotten.
Note also that an investor is not necessarily a fool if the future happens to unfold differently than he predicted. His assessment of opportunities and risks may have been reasonable at the time he made his judgment. However, what he may have been concerned about might not have materialized because other factors became more dominant. An investor is only a fool, if he convinces himself that he can predict the future, when he does not have a specific record of accomplishment as evidence. Investors who have been lucky and become over confident because of their past luck can become very dangerous to their own future financial welfare.
Tags: random sequences
Personal Financial Planning
- Rational Mutual Fund and ETF Selection (Rational selection of equity and bond mutual funds and ETFs - An Overview
Given the extremely large variety and number of available fixed income and equity investment mutual funds and ETFs, investors need a rational basis to select among them. Without scientific selection criteria and a good understanding of which factors are more or less likely [...])
- Vanguard 500 Index Fund – VFINX – merits the Best +10 Fund Authority Score (The Standard & Poors 500 stock index is the most common equity index fund benchmark in the U.S. The S and P 500 tracks about 75% of publicly traded U.S. equity market asset value. The dominant issue in choosing among passively managed index mutual funds and ETF funds benchmarked against the S & P 500 [...])
- The Cost of Investment Counselors When You Pay Investment Sales Loads (How expensive is financial advisor compensation paid via sales loads?
A sales load might be the method that you prefer to compensate your broker or advisor. If your advisor is truly competent and ethical, he may be able to manage properly the inherent conflicts of interest that are associated with commissioned investment product sales. Even if [...])
- The Optimal Investment Strategy for Individual Investors (The Solution - ONLY follow financial strategies that are scientific, passive, diversified, savings focused, risk controlled, low cost, and tax efficient
A previous article, "The Problem - Straight answers about personal financial and investment planning are difficult to find," summarized important reasons why individuals may experience difficulties, even if they are intent upon doing better with [...])
- The Heavy Burden of Recurring Investment Expenses and Fees – Part 2 (
The heavy burden of recurring investment fees (Part 2 of 2)
< < -- Go to Part 1
By charging fees as a percent of your assets, the investment industry can make their recurring fees seem small – like they are “just a few” percent.
Furthermore, by charging fees against your assets the industry can still bill you [...])
- The Value and Opportunity Cost of Your Personal Investment Management Time (
Your time is valuable, and it should be included in calculations about your investment returns.
Whether you add or subtract value from your assets when you spend time on investment activities should also be evaluated. Some investors spend significant time on the wrong strategies. Instead of adding value, their efforts reduce their investment portfolio performance and [...])
- Financial Advisor and Investment Counselor Compensation Paid by Clients (There are three primary types of client paid advisor compensation: hourly-fee, fixed-fee, and asset-fee.
When choosing an advisor, individuals should first decide the type of advisor compensation that makes them most comfortable. How an advisor is compensated can be a very important issue. When you hire a financial planner or investment advisor, 1) you pay directly [...])
- American Funds – Capital Income Builder Fund – Class A Shares (CAIBX) attain a +4 Fund Authority Score (Fund Authority Scores rate mutual funds and exchange traded funds (ETFs) on the most important economic factors that influence individual investors' net long term diversified investment fund performance. The Skilled Investor developed the Fund Authority Score system to provide individual investors with concise and objective summaries of mutual funds and ETFs for comparisons within investment [...])
- Diversify with Low Cost Index Mutual Funds and ETFs Only (
During the last twenty-five years of the 20th century, mutual fund and exchange traded fund portfolio assembly costs declined dramatically.
Brokerage commissions were deregulated in 1975, and transaction costs have fallen very dramatically since then. Furthermore, well-diversified, low-cost index mutual funds have now become commonplace, while none existed in 1968. The mutual fund industry was still [...])
- Can you really beat the stock market? (
You are not likely to beat the stock market, despite all the cheer leading from the securities industry and the financial media.
When you try to beat the public securities markets, unfortunately you are more likely to trail the market’s return, because of extra costs, taxes, and investment mistakes.
The idea that investors can beat the market [...])
- The most effective strategy to increase your mutual fund and ETF investment returns (
What is the most effective strategy you have to increase your long-term mutual fund and ETF investment returns?
Just reduce your investment fees to rock bottom and buy directly to eliminate all sales loads. This strategy is both simple and entirely within your control. You do not have to be smarter than all those other smart [...])
- The John Bogle Blog and His Financial Article About ETFs (John C. Bogle's Blog and his article about ETFs
This article is a heads-up to people interested in investment blogs and personal finance blogs.
John C. Bogle, the founder of The Vanguard Group, Inc., has a blog called The Bogle eBlog. (If you are wondering about "eBlog," it is an anagram of Bogle.) Mr. Bogle just posted [...])
- American Funds – The Investment Company of America – Class A Shares (AIVSX) net a +3 Fund Authority Score (Fund Authority Scores rate mutual funds and exchange traded funds (ETFs) on the most important economic factors that influence individual investors' net long term diversified investment fund performance. The Skilled Investor developed the Fund Authority Score system to provide individual investors with concise and objective summaries of mutual funds and ETFs for comparisons within investment [...])
- Vanguard Total International Stock Index Fund (VGTSX) lands a +9 Fund Authority Score (The Vanguard Total International Stock Index mutual fund is a low cost alternative for broad, passive index investing internationally. This fund is a composite of three other Vanguard international funds: the Vanguard European Stock Index Fund (55.7%), the Vanguard Pacific Stock Index Fund (24.1%), and the Vanguard Emerging Markets Stock Index Fund (20.2%). The percentages [...])
- Vanguard Total Stock Market Index Fund (VTSMX) achieves a +9 Fund Authority Score (
The diversified investment fund strategy of the Vanguard Total Stock Market Index Fund
According to the Vanguard website, the investment strategy of the Vanguard Total Stock Market Index mutual fund is to use a "passive management—or indexing—investment approach designed to track the performance of the MSCI® US Broad Market Index, which represents 99.5% or more of [...])
Comments are closed.