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Was That Skill, or Just Luck?

When the markets start rising, it's easy to get confused about what is responsible for the returns

One of the easiest--and most lethal--mistakes that investors make is to mistake luck for skill. Over the last few weeks or months, the equity markets have started a fairly broad surge upwards. There's no shortage of investment advisors, analysts and brokers who are claiming success for the rising tide that is lifting all boats. Warren Buffett's famous comment on this was that it's only when the tide goes out can one find out who's been swimming naked.

The metaphors are a bit mixed, but at least the tide that is being referred to is the same. I can extend this a bit by saying that now that the tide is rising, the only way to discover the truth is to think back to what was happening when the tide was out. That is, the period from 2010 to early 2014 when the stock markets were drifting along, being highly selective about which stocks and sectors would do well and which wouldn't.

It's easy to stand up today and claim success in identifying stocks that are doing well, but perhaps investors should pay more attention to the investment managers who have actually done well during the dry period. If one analyses diversified equity funds that invest in Large and/or mid-cap companies, then the four years ending 2014 is an interesting revelation. Of the 140-odd such equity funds that were operating over this period, half beat the Sensex and the Nifty. Not just that, some 25 per cent of them beat the Sensex by a margin of over 10 per cent over the period.

That was skill, whereas generating returns now is just luck. Actually this business of confusing luck with skill operates at another level. When their money is growing rapidly, investors start attributing a high degree of skill to themselves for having invested the money well. That's when things get really dangerous.