Win or lose, are you lucky or shrewd?
Recent polls shows that people put good returns down to skill while bad ones are blamed on bad luck. But now there are calls for a more scientific approach
Traders work on the floor of the New York Stock Exchange: Research indicates that returns are usually dictated more by chance than skill. Photograph: Justin Lane/EPA
Does luck trump skill in investment. Research indicates that returns are usually dictated more by chance than skill, and it’s hard to tell the difference between a good investor and a lucky one.
Bill Miller was a legendary figure in the US investment world, having beaten the S&P 500 15 years in a row between 1991 and 2005.
Christened the “greatest money manager of our time” by Fortune magazine in 2006, it all went wrong in 2008, when his shareholdings lost 55 of their value. By the time Miller announced his retirement in late 2011, his fund’s assets had fallen from $20.1bn to $2.8bn, having underperformed markets for five of the six previous years.
Was Miller’s winning streak a product of dumb luck? Was he unlucky at the end of his career? Might it have been a bit of both? How do we know which money managers have been skilful, and which ones have been lucky?
“If you ask a bunch of people to flip coins, maybe one out of a thousand will flip heads 20 times in a row,” says indexing guru John Bogle. “In our business, we’ll declare him a genius.”
ChanceAnother advocate of index funds, Nobel economist Eugene Fama, agrees, saying investors don’t understand the effects of chance on returns.
In one study analysing 3,156 funds over the 1984-2006 period, Fama found that overall, actively managed funds underperformed markets. Only a tiny percentage – about 2 per cent – delivered results outside what could be expected by chance. Investors could profit by picking such funds, but there was one problem – the good funds were “indistinguishable from the lucky bad funds”. There was no way of telling for sure if the managers in question were highly skilled or lucky.
Outcome biasOrdinary investors, unfortunately, often confuse brains with a bull market. In a recent study, Self-Attribution Bias in Consumer Financial Decision-Making: How Investment Returns Affect Individuals’ Belief in Skill, researchers asked clients of a brokerage firm if the recent performance of their portfolio accurately reflected their investment skills.
The higher recent returns were, the more they agreed with the statement. The poorer their returns, the less inclined they were to agree. In other words, good returns are the product of skill; bad returns are a case of bad luck.
If self-attribution bias is a problem, so is outcome bias. Many business books, for example, select a handful of top-performing companies and then look for secrets to their success.