Worth Reading

Worth ReadingI wrote about probability earlier this week within the context of the unlikely and astonishing conclusion to this past Sunday’s Vikings v. Ravens NFL game. Such probability questions are looked at again here, with the added bonus of showing how a poker hand with similarly unlikely outcomes could have played out. Enjoy.  

If Ravens-Vikings Was A Poker Game

Betting on Investment Skill

Deanna BrooksIn 2006, the TradingMarkets/Playboy 2006 Stock Picking Contest was won by Playboy’s Miss May of 1998, Deanna Brooks (shown right). Her portfolio, which bet heavily on oil and gold stocks, gained 46.43 percent on the year and every stock in it provided double-digit returns. She liked Yamana Gold because “What girl doesn’t like a little bling? I’m hot for gold this year.…” It wasn’t her only nugget of sterling analysis. She also liked Petrobras because “oil is making money” and IBM because computers “aren’t going away.” She wasn’t the only Playmate to find a rich vein of success. A higher percentage of participating Playmates bested the S&P 500’s 2006 returns than active money managers. Think about that for a moment. Over the course of a full year, a bunch of Playmates outperformed a whopping majority of highly trained and experienced professionals with vast resources who spend all day every day trying to beat the market.

It’s easy to say that the Playmates got lucky, and they did. But we’d never expect a guy swimming laps at the YMCA to beat Michael Phelps across the pool, a girl off the street to beat a Grandmaster in chess, or an unschooled janitor to solve an insanely complex math problem amidst a spot of cleaning in the afternoon that the best and the brightest need years to figure out. Not even once.

If something like that actually were to happen, we’d treat is as a marvel (as the movie, Good Will Hunting, excerpted above, does), not just as a whimsical curiosity to be used for the purposes of garnering a bit of publicity and ogling attractive women.

It’s tempting simply to say that the contest is too small a sample size to be meaningful and move on. Had she stuck with investing, Miss May’s performance would miss and miss by a lot, probably sooner rather than later, as all investment performance tends to be mean reverting. But we also know that sample size doesn’t mean much when little luck is involved. It doesn’t matter how many times I race Michael Phelps. The chances of my winning will always be vanishingly small — effectively zero.

It’s also important to emphasize (as Michael Mauboussin did in his excellent book, The Success Equation and at The Big Picture Conference recently) the paradox of skill when it comes to investing. As overall skill improves, aggregate performance improves and luck becomes more important to individual outcomes. On account of the growth and development of the investment industry, John Bogle could quite consistently write his senior thesis at Princeton on the successes of active fund management and then go on some years later to found Vanguard and become the primary developer and intellectual forefather of indexing. In other words, the ever-increasing aggregate skill (supplemented by massive computing power) of the investment world has come largely to cancel itself out.

These explanations are good as far as they go, but they hardly tell the entire story. Lady Luck is crucial to investment outcomes. There is no getting around it. Managing one’s portfolio so as to benefit the most from good luck and (even more importantly) to get hurt the least by bad luck are the keys to investment management. Doing so well is a remarkable skill, but not the sort of skill that’s commonly assumed, even (especially!) by professionals. 

More to the point, if investment returns depend that heavily on luck and real investment skill is that elusive and rare, what should we do with our (or our clients’) money? For some answers, we turn to the world of…poker? That’s right — pokerContinue reading