Learning About Skill Vs. Luck

Includes: SPY
by: Roger Nusbaum

A Seeking Alpha reader left an interesting comment on the syndicated version of my recent post about Hugh Hendry:

As a new investor, I struggle with the following some of these Hedge Funds have when I see that I am outperforming almost all of them, and so is the market... why not buy an ETF and save the 2 and 20?

This leads to a couple of interesting ideas.

A long time ago, I heard the saying that the worst thing that can happen is to make money on your first option trade. The idea here is along the lines of confusing genius with a bull market, or skill versus luck. Much has been made about the extent to which hedge funds are generally lagging the S&P 500 this year. The broad scope of what "hedge funds" target makes the point useless.

Additionally, I would submit that the true test of a hedge fund or other managed pool of capital is not whether it is up 20% when the market is up 15%, but what it does when markets are relatively tougher to navigate. Also completely ignored is the concept of risk adjusted returns, which we talk about quite regularly here. As the above new investor's process evolves, he will probably become more aware of risk adjusted.

Back to overconfidence. At times, everyone gets cocky about their ability, most likely after a hot streak of some sort. Who knows how new of an investor the above commenter is but at some point, we all learn a lesson about how good we are versus how lucky we are.

There is nothing wrong with being lucky -- I attribute luck to a lot of things in my life. The key here is knowing the difference and knowing what your wheelhouse actually is. Long-time readers will know I am all for expanding your wheelhouse, but it is unlikely anyone will be an expert on biotech stocks after reading one article in Money Magazine while waiting at the airport.

Most people can learn what it takes to be at least moderately successful (which along with an adequate savings rate, can be enough to get the job done) at constructing a sophisticated portfolio, but there are no shortcuts.