I like how that title implies that risk has a positive or negative connotation. I’ve seen people talk about “positive” risk, which is a corruption of the original meaning, but I can’t think of a better word that indicates the improbability of being one of the high-flyer Buffets or Tudor Jones’s of the world. This is all by way of saying that after Sacha’s positive review of Jeff Rosenthal’s book on probability, I’ve been thinking about how the profit and success of the totality of people invested in the market, from the extremely short term to the extremely long term, probably fits the good ol’ Gaussian distribution, meaning that on average there are a lot of people that have middling returns, some that are doing well and some poorly, and some people being taken to the cleaners (my friend, he of RIM shorting fame is a case in point) while others have more money than the GDPs of most medium-sized countries. Although I’m not a believer in efficient market theory and have my doubts about any form of mathematical modelling being signficantly better at outperforming, I’m pretty sure this distribution holds, which means that for all the scrabbling and statistical analysis and financial document reading we all do, on the whole most of us aren’t going to do all that well, optimistic though we may be. Or am I wrong to assume such a distribution? I don’t know, and I think I might do some more research into this, but it seems that if somehow enough investors were savvy enough to shift the Gaussian’s middle to the right (this is apparently called negative skew), that this would not be an equilibrium condition, that the underlying set of investors would modify their strategies accordingly and the effectiveness of the investing that allowed the skew to exist would stop and the distribution would become symmetric again. This is all just hunch and I don’t know if it’s supported by any research in finance, but it does make me wonder if an individual investor can actively “displace” someone else who is also attempting to succeed. That is, if I go about my day thinking I will do very well in the market, and I am able to develop “skills” (arguable that this is a skilled game, still) to do well, to balance that out, due to the zero-sum nature of investing, the other side of all my trades will have negative effects. Is that the mechanism that ensures such a distribution? Without people blowing up, would it be possible for Buffett to exist? Or put another way, does Bill Gates have a fortune because a million other companies went out of business?
I probably sound pretty naive with respect to the underlying math, but it’s something I wanted to get down so I could explore it more later. I don’t think it is incompatible with the concept of skill in investing, but if it were true, it would imply that it’s not really possible to actively work towards being Buffett — Buffett’s success is in good part the winning of a lottery ticket, as he’s been quick to say (although he meant in terms of a genetic lottery, where he gained the propensity for “investment skill” through birth). In his essay The Super-Investors of Graham and Dodd-ville, he puts forth the idea that the sheer number of successes among the top investors is due to their common value philosophy, but is it also not possible that at the time when all these people were building their fortunes, that value philosophy worked? If Buffett and co did not exist, and we looked at a different timeframe, would there be a growth investor out there writing an essay about how the top investors in the world all seemed to search for growth? How does the success of a small subset of investors in a relatively short span of time (less than a century) indicate the worth of their philosophy? Were there value investors throughout the ages, Buffetts of their time? In the longer scheme of things, say over a thousand years or ten thousand, will his methodology stand up? I suspect that the mid-century success of Buffett may be more anomalous than he thinks, and less attributable to his modification of Graham’s philosophy. In my opinion, it was likely a lucky confluence of that strategy and the environment that have made the majority of his fortune. One factor that comes to mind is the rush of money that has come into the stock markets since the time he started, making the earliest investors the most successful, but can we honestly use the past character of the market to predict the future movement of the market? “The market always goes up in the long run?” Says who? Not to implicitly doomsay, but I can think of a number of markets that no longer exist, or exist in a decrepit form. Why is this homey aphorism considered to be a truism now? It’s something to think about. As William Goldman once wrote, “Nobody knows anything.”