Purposely losing money in the stock market seems like it should be an easy task. It turns out it takes some luck to lose money in the market. The same goes for making it.
Michael Mauboussin defines pure skill-based activities as those where you can lose on purpose. Chess is pure skill. It takes years of learning and practice to become just good at chess. However, a master chess player can lose on purpose to anyone.
Whereas the lottery is pure luck. It’s a random draw. You can pick a series of numbers and hope to lose but there’s always a chance you get lucky and win.
Investing falls somewhere in between pure skill and pure luck because the amount of noise in the system makes it hard to lose (or win) on purpose in the short run.
A good example of this is an interesting experiment run by John Rogers and his team several years ago:
We had some fun with this notion at Ariel this summer. I asked 71 of my associates to pick ten stocks that would underperform the market in the second quarter. Only 19 of them succeeded, meaning 73% of them tried to lose on purpose but couldn’t. Indeed, the average return on the try-to-lose portfolios was 30%, double the market’s return. The lesson: Short-term stock movements are more a function of luck than skill.
There are a number of fundamental characteristics we can look for in companies that are known to produce poor returns. For example, companies trading at excessively high valuation multiples, on average, tend to perform horribly. Companies with declining sales, no earnings, burning through cash, laden with debt, and static to shrinking market share should lose you money too.
Yet, on average is not absolute. Improbable things happen. The market can defy common sense in the short run.
The risk: investors who don’t understand probabilities learn the wrong lesson. It’s like the guy playing blackjack who hits on 19 and the dealer turns over a two! Then forever hits on 19 because he confused an unlikely outcome with a smart decision. Investors tend to attach skill to positive outcomes even when luck is involved.
It’s important that investors separate process from outcome because a good investment process, may have setbacks, but it will produce good outcomes, on average, over time. A bad investment process, may produce a few lucky breaks, but will ultimately lead to ruin.
The problem investors face is that it’s hard to tell the difference between a good and bad process in the short run if you don’t know the difference between a setback and a lucky break. So what makes a good process?
First, a good process is long-term oriented. The shorter the focus the more good or bad luck plays a role, as Roger’s experiment showed.
Second, a good process has a history of past success and makes sense. For example, a process built on mean reversion through stocks with low valuation multiples has performed well over multiple decades. Combining it with other factors with a similar history can improve the odds of success. And there are sound behavioral reasons behind why it works.
Finally, a good process should mitigate behavioral mistakes. It could be a simple checklist. It could be rules-based to eliminate behavioral biases entirely. Whatever your tendencies are, having a set of rules or checks to balance them out builds discipline into your investment process.
Investing is a game of probabilities. A disciplined investment process tilts the odds in your favor. That’s what successful long-term investing is about.
Briefing Book: John Rogers Jr.