skill

Does Skill Really Matter in Stock Market Investing?

Dr Penny Pincher — Wed, 06 Dec 2017 09:00:07 +0000

My young son once expressed concern when I told him I had money invested in the stock market. Perhaps he had seen stories about blindfolded monkeys throwing darts picking better stock portfolios than "expert" traders.

"Buying stocks is just like gambling," he said.

"No, it isn't," I explained.

I am not sure my son was convinced by my explanation, and I began to doubt it myself. What made me so confident that my process of choosing stock market investments was better than random chance?

How lucky stock picks can beat the market

People tend to overrate their investment skills as their portfolio grows. Over the years, the stock market tends to go up and the value of anyone's portfolio — even a portfolio picked by a monkey — would likely go up. But the measure of a successful investor isn't merely getting a positive return on investment. Real success is beating the market by getting a return that is better than the market average. This is where the skill comes in … or does it?

Let's consider randomly selected stock portfolios drawn from the broader stock market. Most such randomly selected portfolios will perform near the overall rate of return for the market. Some of the stocks may perform better than average and some worse, but the ups and downs across the portfolio tends to work out to about average. But by pure luck, some portfolios will end up with more winners than losers and beat the market average. Sometimes these randomly selected portfolios do a lot better than the market average.

For some specific examples, let's simulate portfolios randomly drawn from a market with 10.5 percent return and a standard deviation of 20 percent after 20 years. Under these conditions, the average return portfolio value based on the broader market is $7,366. Here were my "returns" from eight randomly selected portfolios after 20 years:

$4,330
$34,603
$19,572
$9,971
$10,925
$1,482
$8,482
$3,460

You can see that five of our eight randomly selected portfolio beat the expected value of $7,366 from average market returns over 20 years. One portfolio (#2) beat the market significantly, achieving an annualized return of 19.4 percent and growing 4.5 times that of an average portfolio. This portfolio was selected by pure chance, but the performance looks like something that would take a financial genius to achieve. If you were lucky enough to put this portfolio together, people would probably be lining up to ask for your investment secrets to learn how you beat the market. And since you were so successful, you might believe you had actually figured it out!

Our simulation results show that by pure luck, an investor could end up with a portfolio that greatly beats the market. A dart-throwing monkey could pick a great set of stock picks by chance. Random picks can result in underperforming portfolios too, but people tend to notice the big winners.

We have seen how you can end up with a high performing stock portfolio by pure chance. Does this mean that successful investors are just lucky?

The argument for investing skill

As we have seen, it is possible to get lucky and beat the market. But some investors seem to beat the market consistently. It's one thing to get lucky once in awhile, but is someone like Warren Buffett just really lucky, or is there more to it than that?

From reports over the years, we can see that Berkshire Hathaway beat the market 39 out of 49 years, earning more than the market average rate of return. A 2015 paper by James Skeffington uses some simplifying assumptions to analyze the probability that such a run of success would occur by chance. In a simulation with randomly drawn portfolios of 500 companies to represent the S&P 500, Warren Buffett turns out to be luckier than the luckiest of the simulated portfolios by a factor of about 100x.

While this analysis does not conclusively prove that Warren Buffett has exceptional skill as an investor, it does indicate that luck alone is not likely to be the secret of Mr. Buffett's success as an investor.

Should you throw darts to pick stocks?

The conclusion that skill — not just blind luck — likely played a big role in Warren Buffett's investment success means you could potentially study up and make informed investments or find a fund manager that can consistently beat the market through skill. If you want a piece of Warren Buffett's action, you could buy Berkshire Hathaway at a premium or a similar fund at a discount. (See also: How to Buy Berkshire Hathaway and Other Blue Chip Stock for 17% Off)

But in general, past performance does not predict future performance. If you see a fund that is advertising good recent performance, it does not mean the fund will stay hot. It is impossible to know if a fund manager is good or lucky, and investment strategies that work now may not keep working forever.

You could follow Warren Buffett's advice and go with index funds with low expense ratios that take away some of the risks, expenses, and inefficiencies of actively managed funds. As Warren Buffett's famous $500,000 bet showed, a low expense index fund can beat an actively managed fund. This investment strategy allows you to be successful without luck or skill. (See also: Why Warren Buffett Says You Should Invest in Index Funds)

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This article is from Dr Penny Pincher of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

Learn good financial habits from your parents. Or not.

Philip Brewer — Tue, 08 Sep 2009 13:00:02 +0000

One of the big advantages that children of the middle-class and wealthy have is that they grow up in a household where a huge amount of financial knowledge is embedded in its day-to-day functioning. Parents teach it, but it's also just there for the child to pick up, almost for free, like language and basic social skills. If you don't get this basic financial knowledge at home, it's possible to learn it other ways--but don't underestimate how much you need to pick up.

I talked a few days ago about getting your banking services for free. This is something that's routine for any household that's middle-class or higher, but hard for poor folks for several reasons--one of which is just that they don't know how to go about it. But that's just one example. There are so many ordinary good financial habits (like balancing your checkbook, checking your credit card statements, paying your bills on time, having an emergency fund, being careful with debt, challenging vendors who try to overcharge you, having a budget, tracking your spending, saving, investing, and living within your means) that middle-class folks pass on to their kids more or less automatically. It's hard for people who grow up in poor families to catch up.

Obviously I'm using "poor family" as shorthand. Many poor families have great household management skills to pass on to their kids. (After all, a poor family needs great household management skills lots more than a rich family does.) And there are plenty of other things besides poverty that produce the kind of generational ignorance that I'm lumping under the category of "poor family."

For example, immigrants from countries where the banking system is underdeveloped or unsound not only lack basic skills in how to use banks, they often don't even know that those skills are of value--and they're prone to pass those attitudes on to their children. Immigrants also may not speak the local language--and even people who do speak it may not read it well enough to make skillful use of things like bank fee-disclosure documents.

Still, a lot of it is just poverty--people who don't have enough money to meet the minimum balance to get free checking, people who live in poor neighborhoods where there aren't any banks (but are plenty of check-cashing and payday loan places), people who have no financial cushion against small glitches turning into major financial catastrophes. Growing up in such a household makes it tough to learn ordinary good financial habits.

In a middle-class household, the basics of middle-class financial life are being taught all the time in many different ways:

Conscious instruction

Some things are specifically taught. For example, when I was about twelve my grandfather (who was a banker) took me to the bank to make my first deposit. He showed me how to fill out a deposit slip, pointed out what the different lines were for, showed me where to sign the check on the back to endorse it--and explained what endorsing it meant.

Really affluent parents tend to do more of this conscious instruction--teaching their children the proper relationship between family members and the bankers, brokers, and trust officers who deal with their finances. But middle-class parents can and should teach their kids their basics, from how to write a check to how to know when you're being cheated.

Modeling correct behavior

Some things are not so much taught as demonstrated. My parents used debt carefully. I remember that they had a car loan when I was small. When I was a bit older they got a mortgage to build a house on some land they owned, and I remember my parents holding firm when the deal almost fell through over a quarter of a percentage point.

My dad was a college professor and only drew his salary nine months out of the year. During those nine months, he made sure to save enough money (saved out of each paycheck at the credit union) to support us over the summer when he wasn't getting paychecks.

My mom balanced the checkbook every month. It wasn't her favorite household chore, but she did it every month anyway--a habit which I continued until I got married. (Now my wife balances the checkbook.)

Everything parents do while their kids are around demonstrates their values--how much they tip, whether they decide to wait until payday to make a purchase, what they do when a clerk makes an error, which expenses stay in the budget when money gets tight and which get cut.

Letting kids help

I'm old enough that when I was a kid bank statements didn't come with your transactions all sorted by check number. They did, though, come with your canceled checks. So, step one of balancing your checkbook was taking the stack of canceled checks and sorting them into numerical order so that you could mark them off in your check register. When I was about middle-school age, I remember helping my mom by sorting the checks for her. (I remember it vividly, although I probably only did it a few times.)

When I was a bit older I remember paying the household bills a few times--I went through the stack of bills and wrote all the checks and gave them to my dad to sign.

As a small child I'd go grocery shopping with my mom and learned about things like comparing unit prices. I don't know that I was a lot of help, but I was there--not just watching, but participating.

Letting kids manage their own money

Small children will tend to make poor financial decisions for lots of reasons. Their arithmetic skills are still developing and they're still learning things like how to defer gratification. If they have some money of their own, they have a chance to learn this stuff when the consequences of poor decisions are reasonably small--no money for a comic book because they spent it on candy or vice versa.

It's hard to know how much to "help" children make the right choice. Part of the point is for children to feel the pangs of a foolish choice when both the sums and the stakes are small, so it's important to let them make their own mistakes. On the other hand, encouraging a child to save up a chunk of money to be spent on a something the child will enjoy for a long time can go a long way toward developing a life-time habit of thrift.

Casual conversation

Even when there's no actual instruction and when children aren't included by helping, they're still learning all the time. (Learning all the time is what children do. You can't stop it. All you can do is have modest influence on what they learn.)

If the parents are in basic accord, the children will tend to pick up their habits (modified to the extent that they thought things could have been done better). If the parents argue about money, their children still learn a bunch of stuff--that money is important enough to argue about, for one thing. But they also learn from the specific content of the argument. Are they arguing about luxuries versus necessities? Are they arguing about a higher standard of living versus saving? They learn something about each parent's perspective. And, since they have to live with the results, the lesson gets well and truly driven home.

Kids also learn from their friends, their friends' parents, older siblings, their neighbors, and anyone around who has money. They learn from watching and seeing what happens, but they learn in particular from what their parents say about what's happening. Casual comments about this neighbor's failed business or that neighbor having to depend on money from the in-laws make an impression. The kids will also soak up a certain amount of cause and effect from the sequence of events--when the family across the street loses its house in foreclosure, the kids will remember if it's the family that could somehow afford a new pool when no one else could and used to go on two fancy vacations every year.

Teaching yourself

There are lots of ways parents can do a poor job, from failing to do the actual instruction parts to modeling foolish or destructive behavior.

If your parents did a poor job, it falls to you to correct the errors and to fill the gaps. After all, you're the one who has to get by with whatever you know.

Yes, it's a daunting task to pick all this stuff up on your own--especially as an adult, where every mistake can have serious consequences for your family. The fact that it's going to be tough doesn't mean you should skip it, though. It just means that you need to apply yourself to learning all that stuff that luckier people learned when they were growing up.

If your parents did a good job, I hope you'll cut some slack for those whose parents didn't. And, even if your parents did a great job, there's always more stuff to learn about managing your finances.

This article is from Philip Brewer of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

Best investment: yourself

Philip Brewer — Mon, 23 Jul 2007 16:08:15 +0000

I read a lot of investment books. I read mainstream books, where the author assumes the future is going to be a lot like the recent past, but I also like the "economic disaster" books where the author warns that something (government debt, globalization, inflation, energy crisis, stock market crash, real estate debt, hedge funds, derivitives, etc.) will send the economy off the rails. Their portfolio recommendations are so different (stocks, bonds and money markets versus gold, silver, and stockpiled food) that it's hard to find the right path. There is one thing, though, that's always a good investment: Yourself.

By investing in yourself I mean learning a skill. You might need to invest only some time, or you might invest some money as well for things like classes, books, and training materials. Any kind of learning might count, but I'm primarily thinking about learning:

A trade that people will pay you to do
A craft that lets you produce something people will buy
A skill that you can do yourself rather than pay someone else to do

To analyze this as an investment, look at the same three things investment analysts use: liqudity, return, and risk.

Liqudity has to do with how quickly you can turn your investment into money if you need it. You can't just sell a skill the way you can sell shares in a mutual fund, but that's actually one of the upsides of a skill as an investment--it doesn't get used up. If you learn a skill that people will pay you to do you can always generate some cash when you need to. Even one that just saves you having to pay someone else can keep cash in your pocket.

The return depends on the skill and the context. A completely new skill probably won't have as high a return as focusing on whatever skills you already have and maximizing their earning potential, but return shouldn't be analyzed in isolation and it's wise to do both.

Risk is where this investment really shines. Diversification of skills reduces your risk the same way diversification among other investments reduces risk. Good-paying jobs can disappear for a lot of different reasons: technology can automate the work or make it unnecessary; globalization can shift the work to lower-paid workers; a change in fashion can reduce the amount of that work the economy needs. Keeping your primary work skills up-to-date can help, but there's no complete insulation from the vagaries of the marketplace.

Skills not only give you flexibility in a changing marketplace, but they especially come to the fore during times of troubles. A skill can't be stolen, expropriated, or lost in a lawsuit. Nobody is going to default on it or declare chapter 11. You'll never have to leave it behind when fleeing a wildfire, flood, hurricane, or war. You can carry it across international borders and tell customs officials "nothing to declare."

It's worth having some stocks and bonds. But it's also worth having some skills besides the main one you use to earn a living. A little diversification there can get you through troubles where neither a mutual fund nor a safety deposit box filled with krugerrands would help as much.

This article is from Philip Brewer of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread: