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Paul the Octopus and Warren Buffett

Jul 14, 2010

It is not uncommon to see some players become demigods at the end of a soccer world cup. But the recently concluded world cup in South Africa saw an unusual creature become the demigod. We are indeed referring to an eight legged creature who answers to the name of Paul. Or the inimitable Paul the Octopus as he has become widely known these days.

Paul was indeed amongst few or maybe the only one who correctly predicted the outcome of all the matches involving Germany. He even drew the wrath of the local population by pointing out that the German team would fall at the semifinal hurdle. But that made no difference to the overall outcome. He thus, predicted it right, seven times out of seven.

Let us assume that the matches that Paul predicted had only two outcomes. A win or a loss for the German team. Thus, the odds that anyone can correctly predict the outcome of all the seven matches correctly are just a puny 0.8%. In other words, only one out of a group of 128 people will be in a position to call all the outcomes correctly. And Mr Paul the octopus happened to be one amongst a large group of octopuses to have achieved the feat.

Now, let us move on from Paul and football to investing and Warren Buffett. You see, Mr Paul's legendary feet oops! feat can be attributed to pure luck. But can something similar be said about years of outperformance in stock market investing? In other words, can a fund manager's long streak of say 15 years of outperforming the market benchmark be attributed to luck or is it something else?

Warren Buffett, one of the greatest investors of all times attempted to answer this question way back in 1984. And what an answer it turned out to be. Just as now, the prevailing wisdom back then was that markets tend to be efficient all the time. Thus, trying to outperform the market for many years in succession is an exercise in futility. Even if someone manages to achieve the feat, it can be nothing more than pure luck.

Mr Buffett went on to systematically destroy this myth in his piece de resistance, 'The Superinvestors of Graham and Doddsville'. He observed that if one conducted a coin flipping contest for all the 225 m Americans at that time, only 215 winners will be left at the end of 20 rounds. In other words, only 215 people would have called it right 20 times out of 20 out of a population of 225 m people. He further added that if 225 m monkeys would have been placed in place of 225 m people, the outcome would have been the same. Even here, only 215 monkeys would have called all the calls correctly at the end of 20 rounds.

Now, here is the most interesting twist. The 215 monkeys who have emerged victorious are nothing but a stroke of luck. But what if someone tells you that 40 out of those 215 monkeys have come from a particular zoo in say, Omaha, Buffett's hometown. This would certainly force you to conclude that there is more to success in the case of these 40 monkeys than pure luck. Maybe, they share a common gene or have a geographical origin that makes them more able than others to win the coin flipping competition.

Similarly, from a group of successful investors, if quite a few of them choose a stock following a particular investment philosophy, then their success has more to do with the philosophy than pure luck. And this philosophy is nothing but the philosophy of value investing with Benjamin Graham as its founder.

Indeed, quite a lot of investors have managed to beat the market consistently over long periods of time by following the value investing approach. These investors have not cared one bit about the efficient market theory. Nor have they cared about whether the stocks are bought on Monday or Thursday. They have just gone on to exploit the difference between the intrinsic value of a business and the price that its stock trades at in the market. And this all important factor has given them a huge edge over the others.

Thus, like these investors, we too can follow the value investing approach and sharply improve our odds of beating the market. And the good part is that we may not have to rely on the Oracle like skills of Mr Paul the Octopus. Our success would be in our own hands and not merely a statistical fluke as in the case of the famed eight legged creature.

Note: The idea for this article has been inspired by a write up that has come in the English daily, Sydney Morning Herald


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