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Friday, March 29, 2024

Skill and Luck

 

Skill and Luck

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Individual investors are beating the market at an unprecedented rate. I don’t have any evidence to support this bold claim. I just know it to be true.

The most widely held stock of the last decade is Apple, and it’s not even close. Again, I don’t have data on this, but I see a lot of client accounts, and if they hold individual stocks, it’s rare not to see this name.

Over the last 5 years, Apple is up 430%, more than 3x the return of the S&P 500. If you held Apple over that time, if you didn’t hold a lot of cash, and if you didn’t jump in and out of the market, you probably beat the market by a decent amount.*

How much of this was skill versus luck? I was thinking about this because a reader asked:

Curious to hear your take on beating the S&P index as an individual. The past few years I’ve done pretty well with picking individual stocks, beating the S&P 500 by a considerable amount in my Roth IRA. I’m not sure how much of this is skill, versus me being lucky. Any thoughts on this area? How long of a track record of beating the S&P do you think one would need to have to say you’re good at picking stocks, versus just being lucky? 5 years? 10 years?

Before answering this question, we should talk about the role of luck in stock picking. Michael Mauboussin, the author of the best book written on this topic, put it well. He says:

“There’s a quick and easy way to test whether an activity involves skill. Ask whether you can lose on purpose.”

I have zero confidence in my or anyone’s ability to pick a list of ten stocks that will underperform the broader market over the next ten months. Markets are pretty efficient, so consistently losing on purpose requires a great deal of skill. Losing over a short period of time required a healthy dose of luck.

Back to the main question. How long of a track record do you need before you can rule out luck? Unless you’ve got a 50-year one like Warren Buffett, then I really don’t think you can make any claims about being a skilled stock picker. The only reason Buffett gets to is that he was fairly consistent in what he was trying to do.**

Individual investors are not nearly as rigorous in their process. It might be unfair to say that people tend to wing it, but in my experience, that isn’t far off.

Luck and skill are tricky because, as Mauboussin puts it, “Even if we acknowledge ahead of time that an event will combine skill and luck in some measure, once we know how things turned out, we have a tendency to forget about luck.”

This can be dangerous because taking credit for a positive outcome can lead to overconfidence. Especially if the outcome contained an element of chance.  Overconfidence leads to over-trading, which leads to bad outcomes.

Luck and skill are difficult to untangle. But it’s crystal clear that money earned by luck is every bit as green as money earned from skill. There are no extra points for being right for the right reasons. And getting lucky in the stock market is not the same as getting lucky in, say, the lottery. People get lucky in the stock market all the time. All. The. Time.

Most people will not get lucky most of the time. We all know this. But many people picking stocks, myself included, behave as if we’re going to outperform, even if we know the odds aren’t in our favor.

There’s nothing wrong with trying to get lucky as long as your financial life doesn’t rely on it. If you like to pick stocks, then pick stocks, but make sure your livelihood doesn’t rely on it.

*I know I’m making a lot of assumptions here
**Please don’t actually me, Buffett disciple. This is not a biography.

[Image via Pixabay]

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