The results of many years of decision-making in securities will demonstrate how well an investor can calculate mathematical expectation (probability of loss multiplied by size of loss plus probability of gain multiplied by size of gain). Anyone who does not buy an index fund believes, in effect, that he can select individual issues with higher expectancy than the general market. This is impossible for investors as a whole, for it would mean the average investor could beat himself—a logical contradiction. However, I believe that a small number of people can find opportunities with high expectancy, as my track record suggests:

*Listed in order of mention
*Annualized returns approximated

FBEI (Arbitrage)
+13%
Annualized
+80%

SCRJY (Arbitrage & Hedge)
+12%
Annualized
+50%

SCRJY (Unhedged)
+31%
Annualized
+120%

CPTH (Arbitrage)
+21%
Annualized
+210%

CKXE (Arbitrage)
+3%
Annualized
+10%

GCO & FINL (Relative Value Arbitrage)
+205%
Annualized
+820%

ALGI (Generally Undervalued)
-6%
Annualized
-11%

MGST (Arbitrage)
+24%
Annualized
+100%

PSBG (Generally Undervalued)
-35%
Annualized
-80%

CRMH (Generally Undervalued)
-47%
Annualized
-85%

When I wrote about PSBG and CRMH, I knew about their respective operating problems, viz., increasing loan losses and under-reserved self insured groups. I thought that a low price relative to book value and earnings would compensate for these risks. This is ass-backward reasoning; it is wiser to determine the value of a business before looking at the price (which always carries some degree of influence). Since stock prices are very efficient, statistical “bargains” usually have poor underlying businesses. I now believe that low-risk, high return opportunities in generally undervalued securities may come less often than once a year.

My track record for arbitrages and hedges is far better. All selections have been profitable, with annualized returns averaging more than 200% and with disproportionately low risk incurred. I will not change my approach until the stigma against arbitrage fades. Of course this is a very small sample, so large deviations from average might indicate luck rather than skill. To find out for sure, I will increase the sample size over the next few years.

Milton Friedman, a hero of mine, once said something about government efficiency that applies to many other areas—including the investment process. It is good advice to live by:

“One of the great mistakes is to judge policies and programs by their intentions rather than [by] their results. We all know a famous road that is paved with good intentions.”