There is a great post at the Big Picture blog about whether luck or skill is the determining factor to outperforming the market. The short answer: luck is the main determinant. The research has shown this to be the case, but some other points in the article are worth reviewing—first, survivor bias. When research is done on this topic, the researchers will typically look at the funds available today and determine how many of them outperformed the market over the past one, three, five, ten years, etc. The problem with that method (which many have pointed out) is that all inferior performers have probably folded up shop or merged into another fund.
The reason is what statisticians sometimes call the Wyatt Earp Effect. Earp is famous largely for one simple reason: he quite remarkably survived a lot of duels. We only calculate the odds in these highly improbable situations when we already know what happened and are surprised by it. Thus, in terms of predictive value, these instances don’t mean very much at all.
One of the other reasons to be careful reading into outperformance is outright dishonesty:
It’s important to note at the outset that whenever tremendous investment streaks or returns are claimed, there is an important reason (see here, for example) to doubt the factual basis for the claim. Sometimes the problem is mathematical, sometimes it’s a matter of faulty memory, and sometimes people are dishonest. In the “professional” space, it is common to see survivorship bias and phony measurement and benchmarking (for example, asset-weighted performance typically tells a very different story than more traditional performance measures). That’s why, in a discussion of the likelihood of getting “heads” 100 coin-flips in a row (we should expect it to happen once in 79 million million million million million — that’s 79 with 30 zeros after it – fair sets of tosses), the probabilities favor a loaded coin. Barry dealt with this dishonesty among the pros earlier in the year, noting how common it is to hear from “Pinocchio traders.”
But what about some of those traders/investors that have generated outperformance for decades? At what point do you have to attribute some skill to a manager’s outperformance? The author has a story that many of us in the Baltimore area know all too well:
Bill Miller of Legg Mason famously beat the S&P 500 for 15 straight years from 1991-2005. During that time, he was the poster boy of investment skills. Michael Mauboussin calculated the odds against that happening randomly as exceptionally long indeed. Miller himself was much less self-congratulatory. “As for the so-called streak, that’s an accident of the calendar. If the year ended on different months, it wouldn’t be there, and at some point, the mathematics will hit us. We’ve been lucky. Well, maybe it’s not 100% luck — maybe 95% luck.” As Mauboussin points out, such streaks indicate skill, but luck is heavily involved. Indeed, in the five years after the streak ended, Miller lost 9 percent annually and ranked dead last out of the 840 funds in the same category. He lost 55 percent in 2008. That said, he’s hot again now.
By understanding how statistics can be manipulated and how lopsided the research points to luck as the determining factor in outperformance, investors are in a much better position not to be “sold” an investment in some hot-shot fund manager promise of outperformance in a hedge fund. Understanding these simple facts can save you from falling victim to one of the most common sales techniques in the industry: selling performance.
