Part of our job as advisors is to help clients select the best investment vehicles available to them. Many of our clients initially believe that involves picking funds with the best performing managers in the future. Ideally, they would be right. We’d have the magic formula that allows us to pick a mutual fund or other investment that will outperform its peers over some period of time. Many advisors claim to have a method for selecting those investments. It could scrutinize an investment manager’s track record or screen all available funds by several criteria.
But what if there is another explanation on why certain managers will outperform over the next year or two? What if it was almost entirely based on luck? If that were true, a few things would be evident:
- A manager’s past performance wouldn’t matter– if luck were the dominant factor in investment success, then past performance would not tell us anything about the future. It would be like trying to pick who would flip heads more between two coin flippers based on how they flipped in the past. If skill were involved, investment managers with great track records should have a much greater chance of outperforming than an investment manager with a poor track record.
- You couldn’t pick an underperforming manager on purpose– a game that you can’t lose on purpose is based on luck. That is why blackjack, roulette, and other casino games can’t be lost on purpose (when you factor out the house edge). They are based on luck. Investment management is the same. If it is a game of skill, you will tend to see the same result over and over. For example, if I played LeBron James in 100 games of one-on-one, he would beat me every time since it is a game of skill.
- The percentage of managers that continue to outperform will shrink every year– think about my coin-flipping example. If you put 1,000 people in a coin-flipping contest, eliminating any flipper who flips head, you would expect 500 flippers to be left after one throw. After 2 throws, you’d be down to 250. After 10, throws you should be down to about 1 flipper. Performance persistence will shrink over time if investment performance is based on luck.
These are some observations we should see if luck were the primary determinant in investment manager performance. Unfortunately, each one of these points is true. If you think either on your own or through an advisor you will be able to outperform the market, you should read through some of these studies. The evidence is hard to argue with. Luck is by far the determining factor when looking at investment outperformance. That is why we continue to stress that an advisor’s value does not lie in his or her’s ability to outperform the market.
Additional Studies/Reading (if you really want to geek out):
Luck, Skill, and Investment Performance
Luck versus Skill in the Cross-Section of Mutual Fund Returns
Scale and skill in active management