Skilled Investors and Ex-Post Reasoning

Suppose that you’re wandering through a casino with a friend who suddenly takes $2000 (all his vacation cash), and plops it down on red at a roulette game. Fortunately, he happens to win, doubling his money! Which of the following best describes your opinion of his actions:

1. Because he won, he did the right thing.

2. He made a foolish move because the odds of winning were less than 50%.

Reaction number 1 is called ex-post reasoning. This means judging actions by how they work out. Reaction number 2 is called ex-ante reasoning. This means judging actions by the information that was available at the time the choice was made.

I tend to fall solidly into camp number 2, but many people tend to use ex-post reasoning. For example, a basketball player whose coach tells him not to shoot a 3-pointer, but shoots one anyway and makes it might expect praise from the coach. But if the coach leans toward ex-ante reasoning, he or she may still bench the confused player.

The differences between these two types of reasoning show up in active investing as well. It’s well established that active investors as a group can’t beat passive investors because both groups hold the same total mix of investments, but active investors incur more costs. However, it’s still possible for some individual active investors to beat passive investors.

When we say that an investor has skill, we mean that he or she can beat the market. But the number of investors we judge to be skilled will depend greatly on whether we are thinking about this in an ex-ante or ex-post sense. With ex-post reasoning, we would see how many investors beat the market and judge all of them to have skill. With ex-ante reasoning, we would be looking for investors who have an expectation of beating the market. This is much less common.

We can see that having an expectation of beating the market is less common than actually beating the market over some short period of time by observing that while many active investors beat the market for one year, far fewer beat the market over a decade or more. This shows that while many investors happen to beat the market each year, most did it by luck and had no particular advantage in any other year.

The different reasoning styles show up in how investors select mutual funds and ETFs. Ex-post thinkers will keep switching to the latest top-performing active funds, but ex-ante thinkers who look at the long-term record of active fund managers will despair of finding one with genuine skill and are more likely to switch to passive investing.