1. he invests in high-risk assets.
2. he is very good at finding out which companies are well managed and which are not and is clever in understanding market psychology.
3. he is lucky at having stumbled on an investment strategy that has worked well during the last few years.
4. any of the above could be true.
The correct answer is option 4. One cannot rule out the possibility that Joe is a clever interpreter of market psychology or an extremely good evaluator of financial information in determining the future profitability of companies. Nevertheless, if we take a large group of investors acting randomly in their interpretation of market information we will find that some of them will always do better than average for particular short periods. These same investors usually do worse than the market average during other short periods. Over longer time horizons we still observe successful investors although their numbers get smaller as the length of the horizon increases.
Investment "luck" does not necessarily (or usually) mean a fortuitous but randomly varying selection of 50 stocks over, say, a 10 year period. It may mean that the investor, in consultation with his astrologer, reached the conclusion that computers were the wave of the future, purchased a number of computer stocks and held them for five years, during which time the stocks doubled. Then the investor, again consulting his astrologer, arrived at a conclusion that the computer boom is over and that natural resources are going to be in big demand and short supply. By switching into resource stocks at the crucial time, he again doubles his money in a five year resource boom, getting out of computers in the nick of time before their market collapses.
The point here is that the investor in question achieved his success by making only two major investment decisions. When one flips a coin twice, there is a 25 percent chance of both coming up heads. When one flips the coin 10 times there are only nine chances in 100,000 of getting all heads. Our investor only "gambled", or perhaps we should say "plunged", twice, though not necessarily with a 50 percent chance of success in each case.
Another way in which an investor can appear to do better than the market over a very long period is by making risky investments. Stocks that vary a lot with up- and down-movements of the market are more risky and less desirable (assuming risk aversion) because they add variability to any portfolio that contains them. For this reason the market values their earnings less and the ratio of asset value to earnings is lower and the yield correspondingly higher than that of other stocks. Portfolios containing a lot of risky stocks will perform better on average than portfolios consisting of less risky assets, but they also will fall more than less risky portfolios in periods when the overall market is declining.