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Value Investing: Luck vs Skill Part 1

I received this interesting comment from a reader and thought I might write a post or two on this topic:

“…There is one very important writer/thinker you do not mention in your site but whom you might want to pay attention to–the Nobel prize winner Daniel Kahneman. After reading him, you will recognize and appreciate the role of luck, the unpredictability of stocks/markets, and that very few people, if any, can beat the market over the long term.

Sure you can point to Schloss, but if his methods were so easy to emulate, there would be tons of managers following suit and racking up his 20% returns year in and year out over long time periods. But this clearly isn’t the case. Instead, as Kahneman argues, we are overly optimistic and operate under an illusion of stock-picking skill that we can PERSISTENTLY outperform the market when the odds of doing so are extremely slim.”

That’s a great comment and it often provokes some fun discussions in the investing community. I’ll provide my take…

There is One Huge Reason Why It’s Difficult To Replicate Great Results

I think that Schloss/Graham type returns are very possible and replicable for most investors, but rarely do those investors achieve them. Here’s the biggest reason why: It’s very difficult to stay the course when your strategy isn’t working.

As Greenblatt says “Value investing works because sometimes it doesn’t work.” 

I’ve picked apart Schloss’ returns. Here’s an interesting fact I learned from doing that: despite Schloss trouncing the market by 10% per year (20% vs 10% S&P from 1955-2002), he had numerous 2-3+ year periods of underperformance. In fact, there was one period where Schloss actually underperformed for 10 years!

From 1989 to 1998, the S&P roughly doubled Schloss’ results. This means start to finish… there were years in that period he beat the S&P, but an investor who came in at the beginning of that period would still be behind an index fund 10 years later.

How many mutual funds could survive during that length of time? Any investment manager would lose all of their clients after that length of time. Schloss had a small core group of clients in a partnership, and so he was able to continue working the way he always worked without huge withdrawal problems, but probably somewhere around 99% of the time under similar situations, most investors would leave.

Schloss’ Revenge on the S&P 500

Think about that! Talk about patience… Most investors abandon a strategy if it doesn’t outperform for 3-6 months. Some might give it a year or two. I don’t know anyone that would stick around for a decade. Now, here is an even more interesting anecdote: After that 10 year period, Schloss went on a 4 year run where he trounced the market and made up for the entire 10 year underperformance so much so that the overall 14 year record looked outstanding–in fact, it doubled the S&P’s return over the entire period, despite a decade of underperformance. So the S&P’s margin over Schloss was completely reversed 4 years later! So sometimes value investing is underwhelming.

Schloss Track Record 2

Greenblatt talked about this as well with his magic formula. Despite making 33% returns in his backtest from 1988-2004, there were two separate 3 year periods where the system underperformed the market. Most investors would bail after that length of time.

Results Can’t Be Replicated Unless the Concepts Are Completely Internalized

So the strategy, and more importantly, the concepts really have to be seared into your psyche to take advantage of the inherent structural edge that the philosophy has. So it’s not as simple as saying “why couldn’t everyone just copy what Schloss did?” Most in fact could with the proper emotional makeup-but don’t (or can’t) because they don’t have that mindset or discipline. It really comes from the fact that most don’t take the time to really understand the concept. They grasp the concept of value investing at a cursory level, but it’s not embedded into their mind, so they bail at the first extended length of poor performance.

As you say (paraphrasing), “if it was easy everyone would do it”. That’s true. It’s not easy… but not because it’s hard to figure out. It’s not easy because it’s emotionally difficult to stay disciplined when everyone around you is making much more money investing in much different (riskier) investments.

So that’s my main thought on why value investing works over the long term. It works because sometimes (often times) it doesn’t.

In a day or two, I’ll discuss the topic of “luck” in investing in more detail in Part 2 of this post.

Thanks for reading and thanks for the comment!

11 thoughts on “Value Investing: Luck vs Skill Part 1

  1. Funny you bring this up, I was having a similar conversation with a friend he said to me ” I dont trust the stock market, you speak of these guys who over preformed against the market how come more dont do it?” I replied, ” most people are too smart for their own good!”

    Most dont accept the easy answer and instead try to create complicated solutions. The secret has been out for almost 100 years.

    1. Absolutely… Once some basic fundamental parameters are defined, it’s all about implementation over a long period of time, and that is the most challenging aspect.

  2. I often think about Schloss record and what he accomplished it is amazing…

    I concluded now for the last few years that it was the quantitative way and system of buying cheap stocks year after year that made the difference… People think they can concentrate in stocks and analyze a stock in such they understand some businesses so well that this will give them the edge and path to riches, even though they never owned a business themselves, they then put all there money in that business. I see people all the time on seeking alapha trying to do this, I have a hard time doing it and I been a successful investor for over a decade and and have run a very business that I started since my youth.

    Many try to find an edge by thinking they can out think or out analyze others about a business with so much info now on the internet is a fools errand indeed.

    Schloss had a simple system of buying a large basket of cheap stocks without much debt, that were close to 3 year lows, and at low price to book ratio’s, and this is all he did year after year after year.

    This is how most of the greats did it, Schloss, Graham, Templeton, even Buffet in his best years of his early career did similar methods of buying cheap stocks in baskets and using a simple system to follow.

    Simple ways and methods, then sticking to it.

    In fact it is easier to outperform the market than even what Schloss did, and study after study has shown this… You don’t even have to know management or understand the future of an industry, you just have to buy a large basket of undervalued stocks and have a system of doing it and stick with it, through thick or thin. Schloss did well, since he had a system of buying a large amount of cheap stocks over his entire career, it is all he knew.

    Almost all of the value investors I have followed had a system and followed it and bought a basket of cheap stocks and used a few simple guidelines to follow, you can call it almost mechanical, since if they let to much human emotions or thinking get in the way it would likely screw up results.

    Just look at the piotroski screen at aaii made 31.2% a year over 15 years..

    The screen did not know management, products, interest rates, currencies, it just kept buying a basket of cheap stocks that meet some simple criteria and this is the results.

    Just look at Tweedy browns study.

    So why don’t others follow it? Well they can’t stick with it like you Mentioned John, for those reasons. But also they think that they can concentrate and pick the best ones, and that they do not need a screen and that they can tweek the system and add more thinking or analyzing to it as well as stock concentration, and that they are better than everyone else thus can out think everyone else to better results so don’t need a simple sytem.

    Ask yourself this question with honesty. How many people can buy a large basket of cheap stocks and do it year after year? Not many. For the rest of you the market is efficient these days and Graham the father of value investing even admitted just before his death in 1976, that the market was now mostly efficient if you want to analyze a stock or think you can out analyze others on a certain stock. this is why he now “advocated the group approach”

    So this is what I concentrate on now, screening and buying undervalued stocks, without much debt, and that are not melting ice cubes.. Can be net nets, buffetology type stocks, or Schloss types, it is all about the system and buying undervalued to simple ratio’s.

    Graham had a simple system so did Schloss, this was the difference…

  3. Darryl

    Thanks for sharing one of the best comments I’ve ever read on a value investing blog.

    You are correct that it is about system implementation and together with searing the philosophy of value investing into your psyche as Johns suggests you’re likely to see great results over the long term. I’m currently experimenting with a Schloss type portfolio and two others that more reliant on earnings and the Schloss portfolio is outperforming the other portfolios and the s&p year to date. One problem I’ve encountered during my analysis is whether or not I’d be able to keep to the system because of its volatility and the sheer craziness of some of the stocks in the portfolio.

    Let the searing of the psyche commence!

      1. David and Darryl,

        Thanks for the comments… yes although it is against our nature, we should view volatility as our friend. Let the market serve us, as Graham said. It helps to understand the companies you own, because when a company you own that you like goes down in value, you should be excited about the opportunity to buy more, which will create more future value for your portfolio.

  4. If you haven’t I strongly suggest Kahneman’s Thinking Fast and Slow, which is not about investing but is general psychology and economics (as well as Larry Swedroe’s columns on SeekingAlpha if you haven’t read those yet!).

    I read that book today. Parts 3 and 4 are highly relevant to investing. Part 3 makes the EMH argument against stock picking, arguments about simple statistical models outperforming experts, and when intuition can exceed those models. But Part 4 is the really standout part because it explains risk aversion and risk seeking scenarios in the context of prospect theory. I believe that prospect theory explains the risk premiums of value and small cap, as well as other risk premiums, but it’s generally useful as a psychological theory of deviations from economic rationality.

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