The Illusion Of Skill In Investing

Investment Analysis Clubs Macro Economic Trends and Risks
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Someone asked me today why Cathy Wood lost so much money for her investors.

There are a lot of “one-hit wonders” like Cathy Wood in the investment field who never repeat their initial success. As Nobel Prize in Economics winner Daniel Kahneman explains "if there was any skill in investment management, you’d see the same group of individuals at the top of the performance statistics each year, like hitters in Major League Baseball, or the leading money winners on the PGA Tour. Instead in investments, the top guy this year is just as likely to be at the bottom of the pile in the next, it’s no different than a game of dice.

It’s remarkable that such a large portion of the US economy is based on the “illusion of skill”.

https://acquirersmultiple.com/2021/10/daniel-kahneman-the-il…

In Daniel Kahneman’s book – Thinking Fast and Slow, he provides some research that exposes the illusion of skill in investing. Here’s an excerpt from the book:

Some years ago I had an unusual opportunity to examine the illusion of financial skill up close. I had been invited to speak to a group of investment advisers in a firm that provided financial advice and other services to very wealthy clients. I asked for some data to prepare my presentation and was granted a small treasure: a spreadsheet summarizing the investment outcomes of some twenty-five anonymous wealth advisers, for each of eight consecutive years.

intercst

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Warren Buffet

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Peter Lynch - Magellan

Sometimes college professors don’t have the right data…

The Superinvestors of Graham-and-Doddsville
“Superinvestor” Warren E. Buffett, who got an A+ from Ben Graham at Columbia in 1951, never stopped making the grade. He made his fortune using the principles of Graham and Dodd’s Security Analysis. Here, in celebration of the 50th anniversary of that classic text, he tracks the records of investors who stick to the “value approach” and have gotten rich going by the book.

https://www8.gsb.columbia.edu/articles/columbia-business/sup…

The Captain

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Warren Buffett

Buffett’s “skill” is that wealthy families are willing to sell their businesses to him at some discount on the condition that family members keep their jobs and positions in the community. It’s an estate planning tool for family run businesses with a value of $100 million or more.

Similarly during times of crisis, BRK is also able to make strategic investments under very favorable terms for the “halo effect” of having Buffett’s imprimatur.

It’s really not stock picking skill. He gets a lot of advantages by reputation and stature.

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BRK shareholder

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Which of brk’s top 25 holdings are family businesses?

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It’s remarkable that such a large portion of the US economy is based on the “illusion of skill”.

As offered before, in Shinyland, everything runs on hype and hysteria.

Pulled up the Fool this afternoon, and, on the main page, read words to the effect “people who bought 25 stocks on the Fool’s list and held for the last five years have a 97% probability of having a positive return”.

lesseee, from 2017 to now:

Dow 30 went from 20663 to 34566

S&P 500 went from 2362 to 4401

Naz went from 5911 to 13790

Russel went from 1385 to 2020

Yet, the Fool claims remarkable prescience in their recommendations not losing money.

And, among the gooroos, we must remember the “Beardstown Ladies”.

Steve

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Buffett’s “skill” is that wealthy families are willing to sell their businesses to him at some discount on the condition that family members keep their jobs and positions in the community. It’s an estate planning tool for family run businesses with a value of $100 million or more.

That may be what’s going on now, I don’t know, but remember that the early history was quite different. Buffett accepted money from friends and invested it; he did quite well and eventually had to stop taking in clients. He bought Berkshire Hathaway as a shell company and made money investing in the likes of Coca Cola and the Washington Post.

For example, during the five years between 1976 and 1981 returns compounded at 44% a year. This compares quite well to the S&P500 rate of 8% for those years.
https://kunaldesai.blog/berkshire-hathaway-returns/

DB2

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captainccs writes,

Peter Lynch - Magellan

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Sometimes college professors don’t have the right data…

The Superinvestors of Graham-and-Doddsville
“Superinvestor” Warren E. Buffett, who got an A+ from Ben Graham at Columbia in 1951, never stopped making the grade. He made his fortune using the principles of Graham and Dodd’s Security Analysis. Here, in celebration of the 50th anniversary of that classic text, he tracks the records of investors who stick to the “value approach” and have gotten rich going by the book.

https://www8.gsb.columbia.edu/articles/columbia-business/sup……

Sure, Peter Lynch was in the right place at the right time and rolled seven 50 times in a row. I’m not saying it can’t happen. Just that there’s no way to identify these guys a priori. And Peter lynch was smart enough to bail out on top and retire at age 47. His similarly credential successors at running the Magellen Fund didn’t fare as well.

Peter Lynch’s and Buffett’s early success isn’t proof that there’s “skill” in stock picking for an investment portfolio. If there was stock picking skill in the industry, we’d actually be seeing more Lynchs and Buffetts.

Here’s a college professor with the “right data”. James Simon of Renaissance Technologies.

Secretive hedge fund Renaissance Technologies’ reportedly sees $15 billion in outflows despite double digit performance
https://markets.businessinsider.com/news/funds/renaissance-t…

Renaissance’s RIEF, RIDA, and RIDGE funds returned a negative 19%, 31%, and 31% in 2020, while the hedge fund’s Medallion strategy generated positive returns of 76% over the same time period. That discrepancy seemed to have woken investors up to the fact that the strategy employed by Renaissance’s Medallion fund is not even close to that of its three public funds.

Medallion fund
https://en.wikipedia.org/wiki/Renaissance_Technologies#Medal…

It is a widely held belief within Renaissance that the herdlike mentality among business school graduates is to blame for poor investor returns.

I wish I could find the article I read a few weeks ago. Some one asked James Simon why he closed the Medallion Fund to new investors in 1993 and doesn’t let the assets under management exceed about $10 billion. What not take that “40% of investment profits fee” off $1 Trillion under management and own the World?

The answer was that Renaissance has a computer algorithm that finds small, fraction of a penny, pricing discrepancies in the stock ticker and is correct in their bets just a bit over 50% of the time. It’s a volume business, but if you let it get too big, others will see how you’re doing it, and the opportunity evaporates.

There’s only some much ignorance you can mine from the tape (i.e., the stock ticker).

If anyone wants to learn more about the Medallion fund, there’s a good article in Institutional Investor.

Famed Medallion Fund “Stretches Explanation to the Limit,” Professor Claims
https://www.institutionalinvestor.com/article/b1k2fymby99nj0…

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And, among the gooroos, we must remember the “Beardstown Ladies”.

And the Foolish Four.

https://en.wikipedia.org/wiki/The_Motley_Fool#%22Foolish_Fou…

intercst

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Buffett’s “skill” is that wealthy families are willing to sell their businesses to him at some discount on the condition that family members keep their jobs and positions in the community.

Buffett’s historically highest returns were achieved in the early part of his career, with his own personal firm named Buffett Partnership Ltd. The company lived from 1957 to 1969, and during its lifetime the famous investor managed to reach a whopping 29.5% average return year on year with his investments in the stock market.
https://medium.datadriveninvestor.com/how-warren-buffet-achi….

DB2

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This discussion thread reminded me of a comment Mark Cuban made a couple of months ago:

“In a bull market, everyone’s a genius”

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The Foolish Four and the Dogs of the Dow information were a good way to learn some basic principles of investing. At the beginning this investing strategy actually worked but it required more then 15 minutes to review the candidates in the list. It really was worthwhile to learn how to read an earning’s report and to listen to some early corporate webcasts.

Old Time Foolish

P.S. After I made an early post on the FOOL about a Disney webcast I actually got interviewed by the Wall Street Journal.

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“The Foolish Four and the Dogs of the Dow information were a good way to learn some basic principles of investing. At the beginning this investing strategy actually worked but it required more then 15 minutes to review the candidates in the list. It really was worthwhile to learn how to read an earning’s report and to listen to some early corporate webcasts.”

Another Foolish investment was Dogs of the DOW, right? It failed when ‘everyone’ jumped in…

During the 1980s, my company offered an in house program on ‘understanding annual reports’. I own a few individual stocks - mostly from my early years of investing…and get the annual reports for each each year. 75 to 100 pages of financial reports. ( bought some zero debt companies that paid decent dividends - they did well) .

Well, what this course taught is you REALLY need to understand all the pages beyond page 3 to figure out how financial sound and how financially the company is doing. Tons of things are buried in the pages 20-70 and unless you understand how they are ‘cooking the books’ a bit, you are really clueless when it comes to future results. Writing things off, shedding unprofitable ventures or departments or programs , with associated write offs, turning property owned into sale and lease back, stock options extended and might be cashed in, shuffling cost structure from here to there - SHOULD require you put in 10 to 20 hours on analyzing a financial report end to end. One obscure statement on page 66 could be a zinger. (about that subsidiary that just was sued and likely to loose for 20 billion for damages for a defective product that was buried deep in the news)… Duh! Plus, of course, knowing what it all means. Excellent course. Went through the company financial report and that of two others - to show how things were really ‘handled’. You can gin up a few more pennies per share earnings in many ways - not all of them good!

After that…it made looking at different companies a lot different. Switched more to mutual funds - broad index.

Buffet doesn’t buy ‘stocks’ - he buys portions of companies…or the entire companies - usually at a significant discount. Even better when they are up against a wall, and he moves in.

t.

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I believe kahunacfa has a 25.4% average annual return.

PSU

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Luck often outshines short-term, and skill can fade long-term. The 1984 WEB letter (linked to by The Captain) lists some long-term winners including the Sequoia Fund with a CAGR of 17% from 1970 to 1984 (S&P CAGR was 10%). https://www8.gsb.columbia.edu/articles/columbia-business/sup…

But since 1984 the Sequoia Fund has only matched the market. And BRK.A outperformance has been trending down. The 2022 to 2042 winner is not clear.

Annual total returns:

from 1985 to 2021  SEQUX  BRK.A  VFINX
       avg          14%    20%    13%
        sd          16%    27%    17%
      cagr          12%    16%    12%
 
from 2002 to 2021  SEQUX  BRK.A  VFINX
       avg          10%    11%    11%
        sd          15%    17%    18%
      cagr           9%     9%     9%

YEAR  SEQUX  BRK.A  VFINX
1971   13%           14%
1972    4%           19%
1973  -24%          -15%
1974  -16%          -26%
1975   60%           37%
1976   73%           24%
1977   20%           -8%
1978   24%            6%
1979   12%           18%
1980   13%           32%
1981   21%    32%    -5%
1982   31%    38%    21%
1983   27%    69%    21%
1984   18%    -3%     6%
1985   28%    94%    31%
1986   13%    14%    18%
1987    7%     5%     5%
1988   11%    59%    16%
1989   28%    85%    31%
1990   -4%   -23%    -3%
1991   40%    36%    30%
1992    9%    30%     7%
1993   11%    39%    10%
1994    3%    25%     1%
1995   41%    57%    37%
1996   22%     6%    23%
1997   43%    35%    33%
1998   35%    52%    29%
1999  -17%   -20%    21%
2000   20%    27%    -9%
2001   11%     6%   -12%
2002   -3%    -4%   -22%
2003   17%    16%    29%
2004    5%     4%    11%
2005    8%     1%     5%
2006    8%    24%    16%
2007    8%    29%     5%
2008  -27%   -32%   -37%
2009   15%     3%    26%
2010   19%    21%    15%
2011   13%    -5%     2%
2012   16%    17%    16%
2013   35%    33%    32%
2014    8%    27%    14%
2015   -7%   -12%     1%
2016   -7%    23%    12%
2017   20%    22%    22%
2018   -3%     3%    -5%
2019   29%    11%    31%
2020   23%     2%    18%
2021   25%    30%    29%
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Luck often outshines short-term, and skill can fade long-term.

And being perfectly tuned for current conditions can mean you are horribly out of tune after even a small change in conditions.

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And BRK.A outperformance has been trending down.

That is a quirk of financial success, it’s easier to get higher returns with less money. After you have bought all the best ideas, what do you do?

The Captain

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