Skill vs. Luck in Investing

by: Felix Salmon

Greg Mankiw seems to think quite highly of a speech that investor Mark Sellers gave to MBA students at Harvard. But although I'm a writer and Sellers says very nice things about writers,most of what he has to say rings false to me. On the other hand, his speech does I think reveal the prejudices of professional investors.

Sellers's speech is about the qualities needed for someone to be a very successful professional investor. He has a pretty clear criterion in mind, too: he uses the phrase "able to compound money at 20% for your entire career" three times in three paragraphs. Now in general there are two views about people who fit that bill. The more common view is Sellers's: that such people are truly exceptional, that they almost come into the world that way ("by the time you're a teenager, if you don't already have it, you can't get it," he writes), and that they share certain traits (Sellers enumerates seven).

The other view, by no means uncommon, is that if you had as many monkeys throwing darts at stock tables as you have investors trying to beat the market, then some small number of those monkeys would end up compounding money at 20% for their entire career.

My view is that someone who has compounded money at 20% for say 15 years straight is more likely to compound money by 20% this year than, say, the average monkey with a dartboard. I also think that there probably is some rare skillset which makes some people particularly good at investing money. But I think it's incredibly easy to overstate both effects, and I think that when it comes to trading (as opposed to investing) strategies, it's pretty much impossible for any individual to consistently outperform.

Where I disagree strongly with Sellers is here:

A lot of you will turn out to be good, above average investors because you are a skewed sample, the Harvard MBAs. A person can learn to be an above-average investor. You can learn to do well enough, if youíre smart and hard working and educated, to keep a good, high-paying job in the investment business for your entire career. You can make millions without being a great investor. You can learn to outperform the averages by a couple points a year through hard work and an above-average IQ and a lot of study.

I simply don't buy it. I don't see that a Harvard MBA or a high IQ is either necessary or sufficient to "outperform the averages by a couple points a year". In fact, all you need in order to outperform the averages by a couple of points a year is to buy the index and also sell a bunch of out-of-the-money puts on it. That strategy will work perfectly for many years, until it doesn't. (The really gutsy players, of course, wait until the market is in panic mode, and then start selling puts.) At the same time, there are many more very bright people who have lost millions in the stock market than there are very stupid people who have lost millions in the stock market. Intelligence can be a double-edged sword.

As for the idea that great investors are also very good writers, I don't buy it. (Do you know anybody who's actually read an entire book by George Soros, cover to cover?) And then there's this, which I think is almost self-evidently false:

A swing up or down over a relatively short time period is not a loss and therefore not risk, unless you are prone to panicking at the bottom and locking in the loss.

If Sellers were running Citi or Merrill, I guess, there wouldn't have been any write-downs at all: if you're not selling at a loss, then there can't be any losses!

Now Sellers does make some good points along with the weak ones. An MBA won't make you a good investor. There's a big difference between being a contrarian in theory and being a contrarian in practice. People find it hard to learn from their mistakes. But he doesn't make the biggest and most important point of all: to make money on the buy side, the most important qualification you can have is to be lucky. The reason he doesn't say this is because he's an investor himself. And I'm sure he'd rather think of himself as particularly skilled than particularly lucky.