Blog Post

                One of life's never ending debates concerns what makes people who they are.  As each individual has a different genetic background and an infinite number of unique life experiences, pinpointing what causes people to act as they do is difficult.  To simplify, many have focused on two distinct events - nature versus nurture.  Those who espouse the power of nature believe an individual's unique innate qualities dominate.  Therefore, the DNA within your being is the dominant characteristic.  Those favoring nurture, feel that our experiences dictate who we are.  They view us as a blank slate that relies upon life events to determine our personality.  With such a large gap between the two camps, it is not surprising that everyone from 19th century poets to modern psychologists have voiced opinions about whether the answer lies in the nature-nurture extremes or somewhere in the middle.

                As investors, it is important to consider what drives our decisions.  Virtually all of modern financial theory relies upon the assumption that rationale, profit-seeking individuals enter into transactions hoping to minimize risk and increase return.  Within this rationale framework, viewpoints are combined with the net effect being an efficient market where current price equals fair value.  Unfortunately, few purely rationale investors exist.  All of us are composites that at times exhibit rationale decisions and at other times exhibit emotional decisions.  The drift from rationality causes markets to move beyond fair value and offers opportunity for profit.

                If we return to the nature versus nurture debate, what qualities are needed to be an excellent investor?  While I would love to offer a clear, decisive answer, reality is harder to discern.  Since investing is a process that is both mechanical and intellectual, nature and nurture can both claim superiority.

                When looking at our investment performance, virtually everyone focuses on how their investments have changed in value.  If your account increases in value you are happy and if it decreases in value you are upset.  This is a natural reaction as good investments will ultimately be profitable while poor decisions will be unprofitable.  What makes this evaluation much more difficult is how often the analysis is performed and what caused the performance to occur.

                We invest in stocks because they offer superior risk adjusted returns over time.  From 1926 through 2005, equities had an annual geometric mean return of 10% with a standard deviation of 20.5%.  Assuming that performance is similar over the next 80 years and that prices move in random patterns, the probability of positive return over various time periods is as follows:

Time Horizon

Positive Return Probability

1 Hour

50.40%

1 Day

51.20%

1 Week

53.19%

1 Month

56.36%

1 Year

72.60%

10 Years

99.90%

100 Years

100%

As shown in this chart, increasing the time horizon increases the probability of positive return.  However, most investors focus on short term results with the belief that every piece of data yields significant information.  Unfortunately, increasing data often results in excessive noise with little incremental value.  So should we simply invest, relax and wait for positive results?  No.  Knowing that anyone who bought the S&P 500 in March 2000 and sat tight has lost money over the last eight years, sporadic review is no better.  The trick lies in determining both the proper review timeframe and review process.

                When making an investment, many factors drive our process.  Momentum investors may look for chart patterns while a value investor examines the balance sheet.  Regardless of your approach, a process dictates how you make decisions.   The following diagram shows a matrix of process versus outcome with the four possible combinations we can observe:

Good Outcome

Bad Outcome

Good Process

Deserved Success

Bad Break

Bad Process

Dumb Luck

Poetic Justice

Knowing that a good process can yield a bad outcome while a bad process can yield a good outcome, we must resist the temptation to assume all positive investment derive from excellent decision making. 

                The focus upon process and methodology speak to skills that are acquired over many years.   Reliance on experience would strengthen the argument of those who feel nurture dominates nature.  While I understand that line of thinking, it is too simplistic.  If process alone could guarantee results, the use of black-box, quantitative methods would.  However, virtually every financial crisis over the past twenty years has the reliance of quantitative methods at its core.

                Obviously some investors are better than others.  From Warren Buffet's remarkable track record to Bill Miller's streak of beating the S&P 500, certain individuals and groups have performed better than others.  Since every transaction requires two participants, any investor beating the market must be offset by an investor underperforming the market.  Combine enough people and we will see that roughly 50% outperform with the other 50% underperforming.  Given this 50/50 split, the statistical probability of one investor continually outperforming over many years is low.  While this thought process is understandable, I believe it is wrong.

                Leaning toward the nature camp, inherent skills allow certain investors to think through issues more clearly and make better decisions.  The result is that the likelihood of sustained outperformance increases.  As an example, assume you have two basketball players shooting foul shots.  The first is a 90% shooter and the second is a 60% shooter.  If they decide to see who can make 5 shots in a row, there is a 59% probability that the first shooter will win and an 8% probability that the second shooter will win.  A higher level of skill alters the equation to favor the first player.

                So where does all this leave us?  In the end, a good investor must increase the value of their portfolio over time.  Eventually, skill and a good process will yield positive returns that allow you to achieve your goals.  However, interim results often dictate investment action and may cause poor decisions.  The key is to determine whether you are executing a good process in a disciplined manner.  Over time, the adherence to this process will allow you to make more good decisions than bad and to see your wealth grow.  By finding the mid-point of the nature versus nurture debate, you can pick positive aspects from each discipline and develop an investment thesis that allows you to leverage your innate skills, combine them with a good process, determine the proper review timeline and let the positive results take care of themselves.