VALUE INVESTING
Why Investing Takes Skill

By Stephen Bland (TMFPyad)
August 27, 2004

There's an old argument over whether long-term success in the stock market owes more to luck than skill or vice versa. Most ascribe such success to skill but one writer, suggesting that the luck element may be the more important, hypothesised a situation where, by chance not skill, half of a number of investors outperform a given benchmark each year and half underperform. The following year, of the previous outperformers, since it is pure chance again, half beat the benchmark and half do not and so on.

After a number of years you are left with one individual who has beaten the benchmark every year and thus appears to be supremely astute, whereas the truth is that this has been achieved by pure luck. He's just the last one left in this game of chance elimination.

A completely unreal situation in my view, but I think the story was invented to suggest that fund managers in particular cannot be selected on past performance, because there is the risk that they may have achieved that status by chance not skill. If so, buying on past performance will not necessarily ensure future performance. Which sounds like the standard risk warning in fund ads. I don't accept this in all cases, though it may apply as a generality. But the key to investment outperformance, whether funds or individual shares, is to go against generalities, to do what many others think is wrong. Not just for the sake of it but because you have proven to yourself that this is the way to go.

It's like that old criticism of high yield shares. Namely that they are likely to be those in trouble and thus should be avoided. Whilst there is some truth in that, it is a generality. In practice a selected portfolio of high yield shares, far from being a losing strategy, is in my view one of the most likely ways to beat the market over the long term.

When I was advising investment clients years ago who wished to be in funds, my own research into the equity income sector revealed that a number of funds there repeatedly beat index trackers long term and importantly with lower risk. I found in some cases a certain amount of consistency of performance upon which investors might be able to place limited expectations. No guarantees of course but some amount of repeat tendency.

My personal view is that repeated outperformance, whether of funds or investors in individual shares is almost certainly due much more to skill than luck. I say this because I don't believe that investment is a game of pure chance as suggested by the above story. Tossing a coin is luck but shares just don't have in my view an equal chance of winning or losing. They vary greatly in their qualities with certain shares having characteristics making them more predisposed to winning or losing. This doesn't mean you can ever know for certain which shares will win or lose, you have to take risks, but it does mean that the likelihoods of going in a certain direction can be discovered. And equity investing is all about likelihoods not certainties.

Someone winning the lottery, now that is pure chance. There are no skills that can be brought to bear in order to improve the chances. But I see investing as more akin to running a business. In business most people fail. Something like 80% of businesses close down within five years. Of the rest some scratch a poor living, some do reasonably well, and a tiny number make a fortune. These results are not due to chance, they are down to the individual skills of the people concerned. Yes a bit of luck always helps but primarily it is the person who counts.

Investing is something like that. Forget the super investors with billions, you won't be reading this if you're that type, the more realistic aim is to make the far lesser yet still substantial amounts that will create financial independency or at least a large proportion of it. To do so you must be willing to take reasonable risks, be dedicated to investing fully and to find a strategy that will deliver long term. I believe that value shares for those who like shorter term trading with potentially higher rewards but higher risks, or high yield portfolios for those that prefer long term holding, are the ways to go.

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