Luck or Skill to “beat the market” consistently?
Date: Tue, 02 Jul 2013 11:37:54 -0400
One of the reasons that it is so difficult for any investment manager, broker or mutual fund to “beat the market” consistently is not because these individuals or companies are dumb — quite the opposite, it is because they are so smart! We’re talking here about MBA’s from Harvard, U. of Chicago, Wharton, Stanford, Northwestern (there DC, I gave your grad school a nod), et al. What you have is all of these really smart people, with access to huge amounts of data and resources, looking under the same rocks for the next Google or the overlooked bargain, that it is almost impossible for any one of them to gain an edge over any other. Add to this the fact that we live in a 24/7 world where news is instantaneously distributed and available to just about everyone on the planet at the same time. Thus, at best, they all turn out to be average — or, when you subtract the costs of research and transactional frictional costs involved — below average.
Are there those who outperform the “group?” Of course, there always are and there always will be. However, the trick is to know who these individuals or companies are in advance. This is why reliance upon any investor’s or manager’s past performance is useless in predicting their future performance. Yes, there are those who outperform, but there is virtually no consistency in their out-performance nor any correlation with their performance in any future period.
Thus, when asked to explain the performance of a Peter Lynch, of Fidelity Magellan fame, who outperformed the S&P for 11 out of 13 years or Bill Miller with Legg Mason who had a similarly stellar record, there really is only one explanation, since statistically there had to be someone or a few someone’s who would make such a record: luck! They just happened to be the right person at the right place at exactly the right time — but who knew it in advance? Both, as “luck” would have it, had desultory records after their highly successful runs.
Michael Mabboussin had an interesting presentation at the recently held Morningstar conference. Here is a quick report on his presentation:
Mauboussin works for Credit Suisse, Legg Mason before that and has written The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing (2012). Here’s his Paradox of Skill: as the aggregate level of skill rises, luck becomes a more important factor in separating average from way above average. Since you can’t count on luck, it becomes harder for anyone to remain way above average. Ted Williams hit .406 in 1941. No one has been over .400 since. Why? Because everyone has gotten better: pitchers, fielders and hitters. In 1941, Williams’ average was four standard deviations above the norm. In 2012, a hitter up by four s.d. would be hitting “just” .380.
The same thing in investing: the dispersion of returns (the gap between 50th percentile funds and 90th percentile funds) has been falling for 50 years. Any outsized performance is now likely luck and unlikely to persist.
Keep this “luck” factor in mind the next time you see one of the so-called Guru’s paraded in front of you on one of the financial shows and touted as the new, smartest investor in the world or when you see a magazine touting who the “best” managers are or a book that promises to provide the “secrets” that the latest phenom uses.
Copyright (c) 2013
Frederick C. Taylor
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