Tuesday, January 10, 2012

Investing Skill

We often hear that while most investors are better off with passive investing in index funds and ETFs, skilled investors should try to beat the market. The problem here is that the word “skill” here has a technical meaning that is quite different from its everyday use.

The technical meaning of investing skill is more or less synonymous with having better than 50/50 odds of beating the market. So, if the odds are that you’ll beat the market (after costs), then it makes sense to try. But this meaning is very different from the ordinary use of the word “skill”.

Just because you know more about investing than your friends and neighbours doesn’t necessarily mean that you’re likely to beat the market, even though your superior knowledge makes you skilled in the ordinary sense of the word. If I use “skill” with its everyday meaning, here is how I would state the conditions under which it makes sense to be an active investor:

“Active investing makes sense when you are significantly more skilled than the dollar-weighted average active investor.”

Let’s break that sentence down starting from the end and working back.

Why should you compare your skills to only other active investors rather than everyone?

When you are an active investor you can only succeed when you take money away from someone else. You can’t take money away from people with nothing to invest or who are passive investors. You can only succeed when other active investors fail. If you’re not better than your competitors, then you will lose.

Why should you dollar-weight the active investors you compete with?

If some investor is only playing with $500, even if you out-trade him for his entire portfolio, you’ve only made $500 (less costs). When you make a trade, the person on the other side of the trade is much more likely to be someone controlling a huge portfolio than a small one. Your main competition is big players, not other individual investors.

Why do you have to be ‘significantly’ more skilled?

Active investing generally has much higher costs than passive investing. Active traders as a whole pay more in commissions, spreads, and taxes (for non-registered accounts) than passive investors pay. If you achieve average results among active investors, then you’ll still get lower returns than passive investors. You have to clearly beat the (dollar-weighted) average active investor.

Getting back to the technical meaning of investing “skill”, it may be that skilled investors exist. Warren Buffett demonstrated skill over his investing lifetime. Some argue that modern efficient information flow and the increasing number of talented people who analyze markets has made it harder to be a skilled investor. If skill still exists, it must be rare. The next time someone talks about investing skill, keep in mind that this means much more than just being smarter than your brother-in-law.


  1. I like the view in Daniel Kahneman's new book, where he says that the existence of skill is defined by the consistent ability to produce results better than others and financial trading isn't an area where skill seems to exist.

    Then again if the average person underperforms the index with bad trading, an index investor is consistently producing better results than others...

  2. @Value Indexer: I wouldn't be surprised if trading skill doesn't exist. So, being a couch potato qualifies as a skill? I like the sound of that.