I’m trying to determine what I should do with my savings, and purely out of curiosity, I’d like to find the answer to the question, “Can an investor actually outperform the index?”
Which immediately brings me to Warren Buffet and The Superinvestors of Graham and Doddsville. Clearly, they’ve well outperformed the index and all follow a coherent strategy. The question then, is this pure luck or is it skill? I think this question is extremely difficult to answer and no one has a definite answer, and hence the value of charlatanism is high in investment. After all, if there were rigorous ways to define investor performance, then there is the implication that we know what the optimal strategy was, and how close to the optimal strategy the investors got. People pretending to be good investors could not be masked by luck.
But as it is, no one knows. In poker, the correct strategy depends only on what cards the players possess, and from that you can measure whether or not someone made the right move or not. The optimal strategy is certainly evident given full information. The only variable that is hard to define is the human on the other side of the table, e.g. (The optimal strategy may be to bet to receive a call, but the opponent will only call bets of value at most X, therefore you should bet X to extract maximum value, if you bet too much you will extract no value from a fold).
In contrast to investing, the way to evaluate a poker player’s skill is on a play by play basis, and not so much on the return a poker player receives on his play. A good poker player eventually makes enough good decisions such that his return will reflect his good play. The number of decisions a poker player makes during the lifetime of his/her career allows this convergence.
In investing, the landscape is incredibly complex, since anything that can happen in the world can effect a players performance. In poker, this would be the equivalent of poker cards suddenly changing or extra cards being thrown into the deck at random times. The expected value of your decisions changes randomly over time, and hence your initial calculation is frequently wrong unless you’re lucky and the world doesn’t change in a way that effects your decision. If you foresaw 9/11, then I applaud you.
Most people cannot predict the future. So how can we make an investment decision that takes this fact into account? I believe the Value Investment strategy of “margin of safety” plays a key role here. It assumes that the initial calculation of expected value is wrong and looks for room for mistakes. The larger the “margin of safety,” the more likely you will make a good return. As a poker player, I find this to be a sound strategy for making better decisions.
So how do you find the “margin of safety?” This implies that you can draw a line in the sand that says how much a security is worth, and this is probably the most difficult part. A margin of safety on the wrong line is deadly. I’m not sure how Buffet does this now, since I think it is practically impossible to find stocks trading below their “instrinic value” (what a company would be worth if it just sold off all its assets). I think he may be simply buying during times when the herd is afraid.
The other problem is that how many performance-measurable decision events does an investor make during a career? Is it enough to allow returns to reflect skill? I’ll let someone else tackle this one.
