One of the most important determinants of investment success is also one of the most underappreciated – luck. The investors who enjoy the cosiest retirements tend to be the luckiest ones. Unlucky investors, on the other hand, could do everything right and still end up with a very disappointing pension pot.
Former financial columnist Morgan Housel, now a partner at the New York-based Collaborative Fund, has pointed out that someone who invested $500 every month into the S&P 500 over the 1980-2000 period would have ended up with an inflation-adjusted lump sum of $396,014.
However, the equally disciplined investor who followed the exact same strategy over the 1962-82 period would have ended up with a lump sum of just $57,264. One group of investors ended up with seven times as much money as their predecessors, simply because their working lives happened to coincide with an especially good 20-year period for the stock market.
These are not isolated examples: similarly wide divergences are seen over other 20-year periods. Quite simply, the range of investment outcomes is worryingly wide.
What if one extends one’s investment horizon to 30 years? Surely that evens things out? Afraid not – the luckiest investors still end up with five times as much money as the unluckiest investors.
Even if you are an incredibly skilled investor, your returns will be dependent on a good dose of luck, Nick Maggiulli of Ritholtz Wealth Management noted last month.
Let’s say you invested between 1960 and 1980 and beat the US market by five percentage points annually. Pat yourself on the back – only the very best investors in the world could manage such a feat.
Alternatively, imagine you’re a completely hopeless sod who lets your emotions dictate your investing, so much so that you underperform the market by five percentage points every year over the 1980-2000 period. Nevertheless, the hopeless sod beats the investment genius: you’d have earned more than in the latter period than in the former. As Maggiulli put it, “the gods always have the last laugh”.
“The greatest money manager of our time.” That was how
in 2006, following “one of the most remarkable records in the history of investing”. Miller had beaten the S&P 500 15 years in a row, something that “puts him in the same league as
, even Warren Buffett”. Soon after, everything fell apart. His fund was decimated by misguided, outsized bets on financial stocks
such as Bear Stearns, Fannie Mae and AIG during the global financial crisis (Miller was later lampooned in the movie of the The Big Short). He stepped down from his main fund in 2011, having underperformed in four of the previous five years. By then, Miller was actually trailing the S&P 500 over a 20-year period. If he'd retired in 2006, everyone "would have thought I was a genius", he said last year. "By 2009, I was like an idiot." Was Bill Miller a lucky investor who got found out? Was he unlucky during the global financial crisis? A bit of both, perhaps? With investing, it's not easy to distinguish skill from luck. Someone might outperform due to their superior insights; alternatively, their outperformance might be because they made a wild bet that paid off. Luck versus Skill in the Cross Section of Mutual Fund Returns, a study by Nobel economist Eugene Fama examining thousands of funds over a 22-year period, found that strong returns were almost always due to luck, rather than obvious skill. A tiny percentage of managers are skilled, but these good funds were "indistinguishable from the lucky bad funds".
People “don’t understand the effects of chance [on returns]”, said Fama. “You’re taking the chance of being with somebody’s who’s not just lucky, but actually bad.” Napoleon purportedly said: “I have plenty of clever generals. Just give me a lucky one.” That might be equally true for the active investment business.
Right manager, right time
Others have a slightly different take. The average fund manager is skilled, according to Standford finance professor Jonathan Berk, and the very best managers are particularly good. Berk examined 5,974 fund returns over a 42-year period and found those who outperformed in the past tended to continue to deliver strong returns. However, fund investors don’t benefit. Why so? Well, imagine a brilliant fund manager outperforms the market by, say, 10 percentage points a year while managing €100 million in assets. Excited investors see the returns and pour money into the fund.
Let’s say that over time, the fund is managing €10 billion. By now, the manager’s outperformance has shrunk to one percentage point per year. That’s still a very good result (the bigger a fund gets, the harder it is to outperform) but by now, the outperformance is swallowed up in fees.
The study suggests, said Alpha Architect money manager Wesley Gray, that "good managers get burdened with too much capital, but that doesn't mean skilled managers don't exist". Prof Berk's conclusion is that skilled managers can "add considerable value but capture this themselves in the fees they charge".
Consequently, there is still “little evidence” that most investors can outperform even by investing with the best funds. The only ones who can profit from the manager’s skill are the lucky few who invested not only with the right manager but at the right time, before the fund grew too large.
Chief executive pay is often tied to a company’s stock price, so top executives can profit substantially if they lead their firm to great things. Then again, they can also profit substantially if the share price gains for reasons that have absolutely nothing to do with them. “It is well-known that CEOs are sometimes rewarded for luck”, writes Moshe Levy, a finance professor at the Hebrew University of Jerusalem, the “classic example” being that of oil company executives who see their pay packet increase with the price of oil.
This is also true of other factors that are outside the control of executives, he says, which raises the question: how much of the pay-for-performance compensation is actually paid for luck? About 90 per cent, according to a statistical analysis conducted by Prof Levy.
"Chance plays a dominant role in determining firm performance", he writes in his 2016 paper, 90 Cents of Every 'Pay-For-Performance' Dollar Are Paid for Luck. Commentators often argue that linking a CEO's stock options to firm performance incentivises them to work harder, but that's not necessarily the case; a talented CEO might work slavishly but even his best efforts will likely increase his pay by 10 per cent or so, which "does not seem like a very strong motivating force".
Other factors – ego, the fear of being sacked, the desire for self-fulfilment – are likely to be “much stronger motivating factors”. Motivations aside, the conclusion is clear: pay-for-performance is really pay-for-luck.