Skill versus Luck

Track records are the stuff of which Wall Street careers are made. The first thing potential investors want to know about a fund before they invest is the fund's past performance. Some managers have made careers off one or two good years of performance. Investors flock to hot performers despite the fact that the admonition “Past performance is not indicative of future results” appears on nearly every piece of fund marketing material. The truth is that in many cases we simply don't have much more in the way of information than past performance. The whole idea of active investment management revolves around the idea of identifying and paying for skilled managers. Nobody wants to pay a manager whose results are based solely on luck.

It is therefore difficult to distinguish the degree to which skill and luck play a role in investor performance. First, we should recognize that investing is a field in which both skill and luck do play a role. Investing is often compared to gambling and most often to poker, and for good reason. There is no doubt that chance, or the cards drawn, plays a role in poker outcomes. Recent research also shows, contrary to what the authorities say, that poker on the whole is a game of skill.

 Unfortunately for investors, our ability to identify skilled investment managers is much more difficult than identifying skilled poker players.

Some argue that finding skill in the world of professional investors like mutual fund managers is like finding a needle in a haystack. Fama and French examine the performance of mutual fund managers and find that before expenses the top 5% or so of managers demonstrate some skill compared with chance.

 The performance picture worsens dramatically once you take into account expenses, which largely wipe out the benefit of skill in the best managers. You can guess what it does for the rest of the mutual fund manager crowd. Anyone looking for skilled managers needs to recognize that identifying skill isn't enough. The challenge is identifying managers whose skill outweighs whatever fees they charge investors.

There is reason to believe that it has become more difficult over time to beat the market. There is little doubt that the investment management industry has become more sophisticated and professional over time. This professionalization also explains why it is so hard for fund managers to beat the market. This phenomenon is what Michael Mauboussin calls the “paradox of skill.” Mauboussin writes: “The paradox of skill is one reason it is so hard to beat the market. Everybody is smart, has incredible technology, and the government has worked to ensure that the dissemination of information is uniform. So information gets priced into stocks quickly and it's very difficult to find mispricing. By the way, the standard deviation of mutual fund returns has been declining for the last 50 years or so, just as it has for batting averages.”

Just like in baseball, investing is awash in statistics. Unfortunately for investors, in most cases we simply don't have enough data to say with any statistical confidence whether a manager's performance was due to skill as opposed to luck. Baseball players get hundreds of at-bats in a single season. Investment managers need to be around nine years, using monthly returns, just to generate a hundred observations. As Aswath Damodaran writes, “One problem that we face in portfolio management and corporate finance is that we get to observe outcomes too infrequently, making it difficult to separate luck from skill.”

One measure that is appealing in its simplicity is streaks. Andrew Mauboussin and Samuel Arbesman demonstrate that streaks in fund performance indicate the existence of differential skill.

 Streaks, and the consistency they imply, are a measure that appeals to our intuition. As any baseball fan knows, there is nothing more frustrating than a skilled but inconsistent baseball player. Streaks can occur in part by chance, but the existence of streaks can help investors distinguish among managers.

Just as the existence of streaks indicates skill, the existence of luck implies mean reversion. Mean reversion simply means that lucky streaks come to an end. There are few corners of the investing world that are not touched by mean reversion. Michael Mauboussin writes: “Importantly, reversion to the mean in the investment business extends well beyond the results for mutual funds. It applies to classifications within the market (small capitalization versus large

 capitalization, or value versus growth), across asset classes (bonds versus stocks) and spans geographic boundaries (U.S. versus non-U.S.). There are few corners of the investment business where reversion to the mean does not hold sway.”

 Given the importance of mean reversion, you would think that investors would be acutely aware of its role when making decisions. Research shows that investors overreact to recent performance, often to their own detriment.

One way in which investors can tamp down on their desire to overreact to recent performance is to become more informed, and comfortable, with an investor's investment philosophy and performance. Transparency plays a big role. Managers who are willing and able to communicate a clear investment process give investors some small comfort that the process is reproducible over time. As well, managers who are willing to acknowledge that luck plays an important role show that they recognize that the world of investing is a challenging place for even the most skilled.

In the end, we all need to be comfortable with our own investment decision making and to trust that a careful approach will yield positive results over time. Howard Marks says it well: “In the long run, there's no reasonable alternative to believing that good decisions will lead to investment profits. In the short run, however, we must be stoic when they don't.”

 We live in a world filled with randomness, and recognizing this is an important step in dealing with our investments in a more measured and mature fashion.

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