The hidden difficulty of consistently beating the market with big gains

In our career as investors, we will all be bombarded with people who claim to produce spectacular rates of return from stocks, metals, or property that rockets up in value.  When we observe these seemingly impossible gains, it initiates a “greed” impulse within our sub-conscious where we wonder why we can’t do the same thing.  After all, how hard can it really be to “crack the code” of market cycles?  If some guy on late night infomercials who barely graduated high school can do it, why can’t we?

hors-toolsBeing a successful investor in assets such as gold (for example) require that you purchase before the price goes up, ride the price up to a new high, and then sell before the price retreats back down in order to secure your gains.  This sounds easy on paper, but requires considerable luck to pull off in practice.  The reason for this is because it must all be done on a compressed time period, since capital held in gold while the price stays flat is effectively stagnant.  The reason for this is because of the opportunity cost you incur when making an investment.

The term opportunity cost refers to the cost of foregone options when making a decision.  When you choose to invest in gold, growth stocks, or speculative real estate, the invisible cost you incur is the cost of the gains you gave up by choosing one form of investment over another.  In this regard, our investing performance is separately impacted by our luck, skill, and patience.  The relative magnitude of these impacts depends on the kind of investments we choose.

The Impact of Luck

It has been noted by many investment managers that it is better to be lucky than to be good.  In many regards, this sentiment is accurate.  People who are lucky have produced spectacular rates of return that incite jealousy in the hearts and minds of other people who possess deeper knowledge of investing, but do not produce similar rates of return.

The problem with luck is that it is a fleeting companion.  Luck gives, luck takes, and luck shows no mercy.  Some people who buy at the “right” time can see the value of their investments soar up to the sky.  Other people who buy at the “wrong” time can see values nose-dive into the ground.  In order to generate spectacular rates of return, we must benefit from luck in some regard.  In some cases, when luck protracts out over an extended period of time, it is frequently assumed to be skill.

The Impact of Skill

Learning to differentiate between luck and skill can be difficult.  Many people make the simplistic assumption that people who earn the highest returns are the most skilled.  In truth, people who earn the highest returns are frequently the most lucky.  The truth of the matter is that we demonstrate skill in our ability to structure our investments in such a way that we limit the downside from bad luck, optimize the upside from good luck, and still produce favorable results if luck is neither in our favor or out to get us.

In practice, this is a much deeper and more robust level of ability than simply producing high returns.  Any idiot who takes a lot of risk and happens to be lucky can make lots of money and get on the cover of Fortune magazine.  What most people fail to see in these cases is how many other people failed and never got their feature profile in Fortune, and the hidden risks of dramatic losses that are being concealed by the same luck that delivered the spectacular gains in the first place.

The Impact of Patience

Patience is the natural complement to skill in the capacity that they combine to create the formula for successful investing.  Investors who develop exceptional skill and are able to pair patience with their skill will experience the highest probability of achieving their goals.  The reason for this is because skilled investors frequently gravitate toward opportunities that generate residual cash flow and possess upside growth potential.  By combining this skill in selecting prudent investments with the patience to wait for compounded growth to occur, we can push our success away from the control of lady luck, and toward the realm of a virtual certainty.

The important factor to consider in this regard is the notion of compounded growth.  Investments that produce cash flows can re-invest those proceeds into acquiring more capital.  Over time, this compounding of cash producing assets begets more cash producing assets that possess a very important characteristic.  This critical factor is that cash producing investments do not need to be sold in order to produce value for the owner.  This means that success is no longer a matter of buying and selling at exactly the right time.

In this way, prudent investors can change the tenor of the investing game.  For most people, successful investing is a matter of luck.  People drift from one iteration of the “next big thing” to the next with each successive turn in their portfolio accompanied by high hopes of big returns and easy money.  Conversely, for prudent investors, success is a matter of time.  By consistently making prudent investments where time is your ally instead of your enemy, it will place you in an optimal position to achieve success with a much higher degree of certainty than those who spend their whole career chasing big returns and are beholden to luck for their personal and financial fortunes.

Action Item: Use skill and patience to tilt the investing game in your favor.  Always be aware of the fundamental truth that high returns accompany high risk, and require exceptional luck.  Instead of chasing the latest fad, stick to the fundamentals that have been the primary underpinning of all real wealth creation since the beginning of recorded history.

 

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