Luck vs Skill in Investing

by Laurence Watchman
June 10th, 2009

It’s easy to make money investing during a boom. You don’t need skill. You just need to know the market’s rising. You then need to borrow $50 for every dollar you’ve actually got, and put the whole lot in an index fund. A couple of years later, the market’s risen 30% and for every $100 invested, you’ve got $1,500. No special investment skills required whatsoever.

The above is a concise summary of the debt-fuelled boom that came to an end in the credit crunch of 2007. Investment bankers with little more financial skill than a jackrabbit earned millions in bonuses for leveraging themselves and their banks as high as the Moon before they were caught with their financial pants down in the bust. The taxpayer picked up the tab for the bust.

Beta, aka Luck

Beta is a statistical measure of market volatility. You don’t need any skill to benefit from it. If you’re in the market when it moves in your direction, you make money. Otherwise, you lose.

In financial jargon, we can say that pre-crunch, the highly leveraged jackrabbits bankers had profited from beta – they had benefited (at first) from the market rising, just as they would have from an index fund. When things went pear shaped, they lost on beta. The market moved in the wrong direction and, like the mom and pop investors who didn’t sell their index funds before the markets tanked, the jackrabbits lost. (Except most didn’t lose anything; the taxpayer lost.)

Alpha, aka Skill

Alpha measures how much you can beat the market by; it is a measure of the skills of investors or traders. For example, if your index fund rises in value with the rising market, you are profiting from beta. If you judge the market is going to fall and you cash in your fund before the crash, you are benefiting from alpha.