What poker, Buffett, and Federer have to do with investing
(Money Watch) My post of September 09 was on the value/need investors have for an entertainment account. One reader offered the following comment: "As I see it there are different types of gambling. Any time gambling involves conceding odds to the house, I'll pass unless the stakes are truly immaterial. On the other hand poker is a game of skill and the best poker player will win in the long run. If you are better than your opponents, no problem. Investing is more like poker. I will only play in poker games when I am the best player. As an analogy, I would play the stock market if I was Warren Buffett. I am not Warren Buffett, nor are most who claim to be. Until I am certain that I am, or have advice from, the best in the game, I'll take a pass on the entertainment account."
While I think the analogy of poker to investing is interesting, there are important differences between the two that renders the analogy inappropriate. The first difference is that when playing poker, the competition is only the players at your table. The level of competition is of an entirely different variety in the world of investing. To help understand the difference the following analogy from my 2011 book "The Quest for Alpha" is offered. (Note, at the time I wrote the book, Federer was the clear number one player in the world. His stats have since changed. Today, Nadal and Djokovic are battling for that spot.)
The quest for alpha is a game played on a different field
Roger Federer is the greatest tennis player of his era and perhaps the greatest ever. No one would consider it luck he won a record 17 Grand Slam singles titles. But what is important to understand is Federer's competition is other individual players. In terms of individual skills, Andy Roddick has a better serve, Andy Murray has a better backhand, Fernando Gonzalez has a better forehand, Rafael Nadal has a better baseline game and is considered a superior player on clay, Radek Stepanek has a better net game and David Ferrer is faster. Yet, Federer is the best player.
The world of investing presents a different situation. The difference is why we don't see persistence of outperformance of investment managers. To understand the difference, we need to understand how securities markets set prices.
- How Warren Buffett would handle today's market
- A stock picker's market? Not!
- Quest for Alpha: 10 Rules for Being a Successful Investor
Dr. Mark Rubinstein, Professor of Applied Investment Analysis at the Haas School of Business at the University of California at Berkeley, provided the following insight:
Each investor, using the market to serve his or her own self-interest, unwittingly makes prices reflect that investor's information and analysis. It is as if the market were a huge, relatively low-cost, continuous polling mechanism that records the updated votes of millions of investors in continuously changing current prices. In light of this mechanism, for a single investor (in the absence of inside information) to believe that prices are significantly in error is almost always folly. Public information should already be embedded in prices.
Rubinstein is making the point that the competition for an investment manager is not other individual investment managers, but is instead the collective wisdom of the market -- Adam Smith's famous "invisible hand." As author Ron Ross points out in "The Unbeatable Market": "The quest for market-beating strategy boils down to an information-processing contest. The entity you are competing against is the entire market and the accumulated information discovered by all the participants and reflected in prices."
Here is another way to think about the quest for superior investment performance: "The potential for self-cancellation shows why the game of investing is so different from, for example, chess, in which even a seemingly small advantage can lead to consistent victories. Investors implicitly lump the market with other arenas of competition in their experience." Rex Sinquefield, former co-chairman of DFA, put it this way: "Just because there are some investors smarter than others, that advantage will not show up. The market is too vast and too informationally efficient."
Let the greats play the game
While the competition for Roger Federer is other individual players (just as it is at the poker table), the competition for investment managers is the entire market. It would be as if each time Federer stepped on the court he faced an opponent with Andy Roddick's serve, Andy Murray's backhand, Rafael Nadal's baseline game, and so on. If that had been the case, Federer would not have produced the same results.
It is important to understand that the results of any game are more dependent on the skill level of the competition than on the skill of the individual competing. In the world of investing, the competition is indeed tough. With as much as 80 to 90 percent of the trading done by institutional investors, it is difficult to think of a large enough group of victims to exploit in order to generate alpha, especially after considering the costs of the efforts -- bringing us to the next important point (which presents another difference between investing and poker).
When Federer plays tennis (or poker, unless he is playing at a casino which takes its cut from every hand) he is engaged in a zero-sum game -- either he wins the match or his opponent does. Investment managers trying to outperform are not engaged in a zero-sum game. Their quest for alpha generates incremental expenses. Those costs include research expenses, other fund expenses, bid-offer spreads, commissions, market impact costs and taxes (for taxable accounts). It would be as if each time Federer stepped on the court he wore a pair of ankle weights while his opponent had no such handicap.
The bottom line is that the nature of investing results in a much higher level of competition than does poker, and with investing, it's a negative sum game due to expenses. The combination of these two factors results in the requirement of a much greater advantage in terms of skill to expect to win the investment game in the long term -- the only term that matters. In other words, unless you see Warren Buffett when you look in the mirror, it's a game you're not likely to win.
Image courtesy of Flickr user slgckgc