Skill-vs.-Luck Investing Has Risky Effects

NEW YORK (TheStreet) -- TheStreet.com alum Barry Ritholtz recently shared a post from investment manager Bob Seawright that explored the difference between skill and luck when to comes to investing. Seawright invoked something called the Wyatt Earp effect where Earp famously survived countless gunfights and while history looks back at Earp as having been very skilled, luck also had to play a very large role.

Seawright continues that Bill Miller's streak of beating the S&P 500 for 15 years in a row as he managed the Legg Mason Value Trust (LMVRX) was by Miller's own account "an accident of the calendar."

Understanding the difference between skill and luck is crucial. When a long, lucky streak is confused with skill it can lead to overconfidence which can then lead to increased risk taking. In managing the Legg Mason Value Trust Miller took big risks despite the above quote attributed to him by Seawright.

He had very large positions financial stocks including Fannie Mae and Freddie Mac going into the financial crisis which he did not sell causing his fund to fare far worse with a 73% drop compared to the S&P 500's 56% decline.

Overconfidence is a behavior that repeats in stock market history. One recent anecdotal example came during the Internet bubble and subsequent tech wreck. As high-flying internet stocks rose, legions of day trading shops were opened around the country so that newly minted traders could quit their regular jobs and easily click their way to wealth as internet stocks kept growing to the sky.

What many thought was easily acquired day trading skill turned out to be luck that soon went bad ultimately leading the first 50% decline of the preceding decade.

Recent signs of similar overconfidence could include 3-D printing stocks. Like the internet, 3-D printing is likely to be life changing. Going into mid-November 3D Systems (DDD) was up 120% and ExOne (XONE) was up 120% from its IPO in February. Both stocks were hit very hard last week; DDD was down 9% and XONE was down 14%.

XONE is down 25% from its high this summer but that did not dissuade Voxeljet (VJET) from its IPO one month ago. After rocketing to a 106% gain in just 18 trading days, it then fell 47% from its high last week.

After a few months of "skillful" trading, luck may have run out on the group... at least for the time being.

The conclusion drawn by Seawright is the need focus on process in order to achieve investment success to which I would add the word discipline. When you can truly accept the role luck plays in investing it then becomes much easier to focus on process and when you know you have a process that can lead to long-term investment success it makes it easier to remain disciplined to your chosen process.

By remaining disciplined you will create your own luck.

This is especially true in 2013 as the year winds down to an end. If you adhere to some sort of investment strategy other than indexing then you have likely lagged behind the S&P 500's 27% gain. Just as Bill Miller realized he would not beat the market every year, neither can anyone else.

If your investment strategy has lagged behind the S&P 500 index you might be tempted to switch to indexing because of how well it did this year. Doing so would be an undisciplined disregarding of process. Through most of the last decade no one wanted to touch indexing with a ten-foot pole as the S&P 500 endured a volatile round trip to nowhere; from March 10, 2000 to May 9, 2007 the index was unchanged. Indexing was no worse back then as today, it just so happens that indexing has beaten most other strategies this year after lagging so many strategies before.

Giving up on a strategy because of impatience once is likely to be repeated in the future which results in repeatedly chasing what was hot last year which will inhibit investment success. If your equity portfolio is up 10 or 20%, your process is not broken, 2013 just one of those years where your process wasn't the best performer and that is ok because no process can be the best performer every year.


At the time of publication the author had no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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