In 2006, a US website for stock traders set a challenge to 10 Playboy Playmates. The rules were simple; the models picked their 5 favourite stocks and the Playmate with the best performing portfolio for the year would be crowned the winner.
At the end of the year, the winner was Deanna Brooks (Playmate of the Month in May 1998). Her stocks rose 43% beating the S&P 500 Index which returned only 14% and, indeed, beat more than 90% of professional active money managers that year. She wasn’t alone – 4 of the other Playmates beat the market too, while less than a third of the active money managers did.
This is not an isolated example.
In 2010, a Russian circus monkey named Lusha picked an investment portfolio that outperformed 94% of the country’s investment funds to great acclaim.
These examples and many others illustrate how investing is a balance of skill and luck.
Only a small fraction of investors have shown an ability to systematically beat the market over time. It is not that investors lack skill, it’s the paradox of skill: as investors have become more sophisticated and information more freely available, the variation in skill has narrowed and luck has become more important.
Wait a Minute
The effect of luck is particularly amplified over short term periods.
In his book ‘Fooled by Randomness’, statistician Nassim Taleb gives a good illustration of this short term effect. Take a fund, he said, that on average returns 15% annually with 10% volatility (or uncertainty) per annum. If you were to look at the statement of account every year, the fund would, on average, be expected to show positive performance in 19 out of every 20 years.
However, look at it on a second-by-basis (and some investors do, being glued to their trading screens) and the same fund only has a 50.02% probability of making money over any given second. Indeed, on a minute-by-minute basis, this only rises to 51.17%. With such a small margin in the short-term, it is not surprising how random luck factors can swing performance and enhance or diminish fund performances.
Thus, luck can seriously distort the outcome of an investor’s portfolio. Even a highly skilled, diligent investor with a great investment process and long track record can have a shockingly bad run of performance. Conversely, another investor with no investment skill (e.g. Playmates) can have terrific performance.
Good Skill Hunting
So, how do we try to distinguish between the skilful and just plain lucky investors?
Clearly, it is very difficult. At Equilibrium, one part of our screening process involves looking at the long term persistency of performance to identify fund managers that can demonstrate outperformance over many years. However, whilst persistency is evident in a few cases, it is not always applicable – for example, if a new fund is being launched and there is no track record to look back at.
Another approach is to ask the fund manager under what market circumstances (e.g. sharply rising, value-orientated, momentum-driven, etc) they would expect the fund to underperform and when they would expect to outperform. This sets out the manager’s own expectations of when his skills would be expected to drive outperformance. If the fund does not perform as expected during these periods, then this is investigated to see if it is due to good or bad luck - or exaggerated claims of investment skill.
By its very nature, luck is random and spells of good or bad luck will reverse over time. It is therefore very important that as investors we are patient too. Rash switching from one fund to another by reacting to short-term performance due to luck rather than long term ability is costly in terms of performance and transaction costs.
In 1994 a chemist by the name of Jayesh Manek won the Sunday Times Fantasy Fund Manager competition. The following year, he entered again and won again. This attracted the attention of legendary investor John Templeton who invested £10m with Manek, who went on to establish a UK growth unit trust in 1997. By 2000, the fund was up by 160% and was worth over £300m. Then things took a turn for the worse and performance fell sharply.
Today, the trust is down 72% in value from the 2000 level compared to the FTSE All Share that has doubled.
Indeed, in our Playmate example bad luck befell one entrant whose portfolio declined 37% alone over the 12 months.
These are salutary reminders of how good luck can flatter but equally bad luck can destroy value and that even seasoned investors can mistake luck for skill. Careful analysis is required and patience necessary to determine underlying skills, however attractive initial impressions may seem.