Who Really Beats the Market?

Survivorship bias, or survival bias, is the logical error of concentrating on the people or things that “survived” some process and inadvertently overlooking those that did not because of their lack of visibility. This can lead to false conclusions in several different ways. – Wikipedia

There is survivor bias in looking at trading and investing performance and then there are the traders and investors that have an edge. People with an edge end up with the losses of those that rely on luck for profits.

This article is from an edited transcript of a talk given at Columbia University in 1984 by Warren Buffett.

Investors who seem to beat the market year after year are just lucky. “If prices fully reflect available information, this sort of investment adeptness is ruled out,” writes one of today’s textbook authors.

Well, maybe. But I want to present to you a group of investors who have, year in and year out, beaten the Standard & Poor’s 500 stock index. The hypothesis that they do this by pure chance is at least worth examining.

I would like you to imagine a national coin-flipping contest. Let’s assume we get 225 million Americans up tomorrow morning and we ask them all to wager a dollar. They go out in the morning at sunrise, and they all call the flip of a coin. If they call correctly, they win a dollar from those who called wrong. Each day the losers drop out, and on the subsequent day the stakes build as all previous winnings are put on the line. After ten flips on ten mornings, there will be approximately 220,000 people in the United States who have correctly called ten flips in a row. They each will have won a little over $1,000.

Now this group will probably start getting a little puffed up about this, human nature being what it is. They may try to be modest, but at cocktail parties they will occasionally admit to attractive members of the opposite sex what their technique is, and what marvelous insights they bring to the field of flipping.

Assuming that the winners are getting the appropriate rewards from the losers, in another ten days we will have 215 people who have successfully called their coin flips 20 times in a row and who, by this exercise, each have turned one dollar into a little over $1 million. $225 million would have been lost, $225 million would have been won.

By then, this group will really lose their heads. They will probably write books on “How I turned a Dollar into a Million in Twenty Days Working Thirty Seconds a Morning.” Worse yet, they’ll probably start jetting around the country attending seminars on efficient coin-flipping and tackling skeptical professors with, ” If it can’t be done, why are there 215 of us?”

———-end of speech————

The above speech by Warren Buffett goes on to explain how members of the value investing school of Dodd and Graham consistently beat the market. If many of the 215 coin flip champions came from the town of Graham and Doddsville maybe their technique gave them an edge. The biggest edge that the value investing world had was safety of margin by buying great companies at greatly reduced prices, the patience to wait for the value to be realized over years, and the edge of buy and hold investing during the booming post World War II economy.

There are other towns where traders and investors consistently beat randomness to make returns systematically over very long periods of time.

Jack Schwager chronicles “Market Wizards” through several books that all have audited long term results far better than the general markets, some for decades. Some of the common themes from these interviews was using a process with an edge, correct position sizing for trades, discipline, the right mind set, and flexibility. Several billionaires came out of Market Wizardville as professors said the markets were efficient.

Michael Covel chronicles “Trend Followers” through his books that also have long term audited track records and have achieved consistently amazing long term results for compounding and returns on capital. These traders are not trading to pay their light bill they are trading for long term growth in capital. They primarily use futures contracts for leveraged returns during sustained trend in price. Their edge is great risk/return ratios with future contracts, reactive technical analysis, diversification across diverse uncorrelated markets, quantified tested trading systems, position sizing based on volatility, along with cutting losers short and letting winners run. Trend following in some form is the best alternative to buy and hold investing. One professional trader from Trend Followingville bought the Boston Red Sox, John Henry.

Don’t ever let anyone tell you that you can’t beat the market, too many traders do it every year. The majority of people that lose money in the stock market donate their money to a minority of traders and investors with the edge of process, risk management, and discipline.