Last year was a great year for US stocks. In fact the Russell 3000 index returned 33.55%. This bested most other indices. For example the MSCI EAFE Index (Europe/Asia/Far East) returned 22.78%, the MSCI Emerging Market Index returned -2.6%, the Dow Jones US Select REIT Index returned 1.22% and the Dow Jones-UBS Commodity Total Return Index returned -9.52%.
This may lead some investors to rethink their strategy. If they owned a diversified portfolio containing a mixture of the above indices they definitely underperformed US Stocks. All they have to do this year is pick the index/asset class that will do the best this year. Sounds easy enough. Anyone who follows my blog though know that there are only three kinds of market forecasters. Those who don’t know; those who don’t know they don’t know; and those who know they don’t know, but get paid a lot of money to pretend they do.
When it comes to investing it is best to focus on strategy, not outcome. Nate Silver in his book The Signal and the Noise had this to say about poker players. “They know that they can play well and win, play well and lose, play badly and win, and play badly and lose. They know the difference between process and results.” He goes on to say, “If you correctly detect an opponent’s bluff, but he gets a lucky card and wins anyway, you should be pleased rather than angry, because you played the hand as well as you could. The irony is that by being less focused on results, you may achieve better results.”
The same is true for investing. Diversification is always the right strategy, even if it doesn’t produce the best results over certain time periods. Someone who put all their money in Delta Air Lines stock last year and made over 100% is just like the poker player you knew was bluffing, but got the Jack of Spades on the last card to beat you. It’s obvious he is not a good poker player but just got lucky. The same is true for the guy who bought the Delta stock. He is not a good investor, just a lucky one. Unfortunately this may lead him to become over confident in his stock picking prowess. This can lead to disastrous outcomes.
Nassim Nicholas Taleb, author of Fooled by Randomness, had the following to say on the problem of confusing strategy and outcome:
One cannot judge a performance in any given field by the results, but by the costs of the alternative (that is, if history played out in a different way). Such substitute courses of events are called alternative histories. Clearly the quality of a decision cannot be solely judged based on its outcome, but such a point seems to be voiced only by people who fail (those who succeed attribute their success to the quality of their decision).
It is not hard to develop a sound investment strategy, but it is very hard to stick to it. Especially when people start telling you how much money they are making with other crazy investments. It’s best to think of these conversations as someone saying, “I went to Vegas and won $5,000 playing roulette.”
