We all know that the outcomes in many activities in life combine both skill and luck. Investing is one of these. Understanding the relative contributions of luck and skill can help us assess past results and, more importantly, anticipate future results.
In Major League Baseball, over a 162-game season the best teams win roughly 60 percent of the time. But over shorter stretches, it’s not unusual to see significant streaks. Since reversion to the mean establishes that the expected value of the whole season is roughly 50:50 (or slightly above or below that level), 60 percent being great means that there is a lot of randomness in baseball. That idea makes intuitive sense – the difference between ball four and strike three can be tantalizingly small (even if/when the umpire gets the call right); so can the difference between a hit and an out.
Luck (randomness) is a huge factor in investment returns, irrespective of manager. “Most of the annual variation in [one’s investment] performance is due to luck, not skill,” according to California Institute of Technology professor Bradford Cornell in a view shared by all experts (Nobel Prize winner Daniel Kahneman talks about it in this video, for example). Even more troublesome is our perfectly human tendency to attribute poor results to bad luck and good results to skill.
The efficient markets hypothesis claims that all market outperformance is attributable to luck. But (as noted earlier in this series) it has been demonstrated, by statistical tests and common sense, that there is a component of skill involved. There is a huge difference between saying investing is all luck and saying it has a lot of luck. But it is important to remember that, on the continuum, investing is closer to the luck side (which is why it is so difficult to profit all the time and to succeed when the market is tanking).
So what constitutes skill in a field where probabilities dominate and how can we recognize it so we can make investment allocations wisely? The key is to choose money managers with more than just a good track record of results. Choose money managers with an excellent investment process too.
In all probabilistic fields, the best performers dwell on process. This is true for great value investors, great poker players, and great baseball players. A great hitter focuses upon a good approach, his mechanics, being selective and hitting the ball hard. If he does that – maintains a good process – he will make outs sometimes (even when he hits the ball hard) but the hits will take care of themselves. Maintaining good process is really hard to do psychologically, emotionally, and organizationally. But it is absolutely imperative for investment success.
The great investor Seth Klarman, founder of the Baupost Group, makes a terrific insight: “Value investing is at its core the marriage of a contrarian streak and a calculator.” The contrarian streak means that a good money manager must be willing and able to do something different from what the consensus is doing. However, investment success draws a crowd and dilutes future success, meaning that one can never “rest on her laurels.”
The issue is complicated further in that sometimes the consensus is right. If the movie theater is on fire, you should run out the door with everyone else, not in. So adding the calculator part is crucial. Being a contrarian makes sense only when it leads to a mispricing between fundamentals and expectations. That is a market opportunity. Finding active managers with that outlook as well as the ability and the psychological strength to execute it well is astonishingly hard.
But there is yet another problem: a portfolio’s results are largely dictated by overall market performance during the applicable time period. In other words, the more risk-averse strategies will generate better returns in a difficult market by protecting the downside and the reverse will also tend to be true, that managers with higher risk tolerances will be more likely to succeed during periods of strong market returns. The conventional method of mitigating this dilemma is to “risk adjust” the results, comparing nominal returns with volatility, but this approach is uncertain at best in that volatility and risk are hardly the same thing.
Accordingly, the decision as to which managers and which funds deserve assets in the current environment, as a practical matter, is often determined — surprise! — by how one does the analysis. For example, analysis using five-year performance numbers will contain the late-2007 onset of disaster and the ravages of 2008, favoring the risk-averse managers. On the other hand, analysis using three-year numbers will be much more favorable to risk-tolerant managers as those numbers will be dominated by the post-March 2009 recovery period and the (in hindsight) relatively sanguine 2010 and the late 2011 recovery.
Whether the three or the five-year performance numbers are ultimately deemed more instructive will largely be determined by what happens during the next couple of years or so. If markets are going to remain spotty for the next two years, advisors that use the five-year numbers will look like geniuses. A strong equity market recovery throughout 2012 will make them look like morons.
Everybody – advisors and clients alike – wants the same thing in the end: high relative returns with a minimum number of sleepless nights. Human psychology being what it is, however, investors are often their own worst enemies. Risk-averse investors, for instance, should want to underperform the benchmark in a bull market. It implies a strategy of risk management that will protect them when, inevitably, the benchmark heads lower. Of course the benchmark is going to outperform that strategy in a sustained bull market. What tends to happen then is that investors, frustrated by trailing the index for a while, switch their money into more aggressive choices right before a downturn (see here for a helpful synopsis of the current – very risk averse – environment). That goes a long way toward explaining why most people underperform.
This “time slice” issue and behavioral economics makes the selection of investments a tricky thing. You may choose not to care about any particular benchmark. You may develop and analyze future financial requirements and then tailor investment decisions to achieving those. What happens to the S&P 500 or other benchmark over some random period of time is then of merely passing interest. But, even so, for an advisor to maintain trust and business in periods of extremes will remain a significant challenge.