A hedge fund manager doubles her investors' money over the course of a year.. A company's stock increases four fold over the course of six months.... these are not unusual news stories but they give rise to one of those enduring questions in finance: Was it luck or skill? The answer of course is critical. If it was "luck", we should not be giving the hedge fund manager 2% of our wealth and 20% of the profits. If it was skill, the company's managers deserve not just a huge thank you but commensurate financial rewards.
As always in finance, there are two extreme outlooks. At one end, there are those who view any superior performance as evidence of skill and extended superior performance as almost super natural. At the other end, there are those who who contend that it is all "luck" and that portfolio managers have any "discernible skill". As an illustration, Fama and French have a damning article on active portfolio management, where they note that all of the excess returns in practice can be explained by randomness:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1356021
In their assessment, all "superior performance" in portfolio management can be attributed to luck. Here is a more recent paper by Andrew Mauboussin and Sam Arbesman that argues that there is some evidence of differential skill:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1664031
Needless to say, this is an issue where researchers have disagreed and continue to do so.
You may disagree with the broadness of the Fama/French conclusions (and I do), but they do point out how difficult it to differentiate lucky winners from skillful winners. To understand why, it is best to look at an arena where the differentiation between luck and skill is easier: sports. Even those who don't like Sachin Tendulkar, Lionel Messi, Tiger Woods or Kobe Bryant have to admit that they have skills the rest of us don't possess and that their success cannot be attributed to luck. So, why is it so easy to separate skill from luck in sports and not so in finance? Separating luck from skill is easiest when:
a. Success is clearly defined: In basketball, you either make a basket or you do not. In cricket, you are out or you are not. In golf, you make par or you do not. In soccer, you score a goal or you do not. An "almost a basket" or "almost par" can be a chatting point with a friend but does not count.
b. It is difficult to have a successful outcome with just luck: I will make a confession. I cannot shoot par on a golf course, make a three pointer in basketball or score a goal in soccer, even with luck. I am awed when I see people do these things, since I know it requires skills that I do not have.
c. Number of trials: Professional sports players get hundreds of chances to show their wares, and luck very quickly drops to the wayside. You may make one three-pointer in the gym, with sheer luck, but if you were asked to shoot a few hundred three pointers, your limitations would be clear to all. There is no way that luck can explain the hundreds of sub-par rounds that Tiger Woods had (when he was a golfer and not a celebrity), the runs that Sachin scored for India, the points (and championships) for Kobe and the goals that Messi has scored for Argentina (and Barcelona) over time.
Looking at finance through these lens, it is easy to see why it is so difficult to separate luck from skill:
a. Success is not clearly defined: Is a portfolio manager who makes money for his investors a success? What about one who beats the S&P 500 each year? Is a company that delivers returns that outstrip the rest of the sector a success a "good" company? The very fact that we have to think about our answers to these questions tells you something about "success" in finance. To be successful, you have to beat your benchmark, after controlling for risk. However, since risk is a subjective measure, it is entirely possible for a portfolio manager to be classified as a success by one evaluator and not by another. With hedge funds and private equity managers, it becomes even more so, since the net risk exposure is often tough to measure.
b. It is easier being successful with just luck in finance: I would not bet my house that my portfolio selections will deliver higher returns in the next year than those of my neighbor, who picks stocks based on astrological signs and has the financial sense of a dodo, or of my 11-year old son, who has never looked at the Wall Street Journal. As I note in my valuation class, there is no justice in the investing world. You can do everything right (collect the data, analyze it carefully, make reasoned judgments) and go bankrupt... and you can be absolutely cavalier in your investment judgments and make millions.
c. Too few trials: Can you be lucky once? Sure! How about 4 times in a row? Yes.. How about 15 years in a row? Not as easy, but with hundreds of people trying, a few will.... One problem that we face in portfolio management and corporate finance is that we get to observe outcomes too infrequently, making it difficult to separate luck from skill.
I don't mean to leave you in limbo. After all, most of us want to separate luck from skill in finance. So, here are the things that I would look for in a "skillful" portfolio manager or a CEO:
a. Consistency: As an investor, I don't want to just see that you beat the market, on average, but that you beat it consistently for an extended period. I am more likely to attribute your success to skill, if you beat the market by 2-3% each year for 15 years than if you beat the market by an average of 2-3%, with more variability and poor years intermixed, over that period.
b. Transparency: I tend to mistrust success, when that success is based on portfolio managers self-appraising the values of the properties and investments in their portfolios. A hedge fund may claim it made a 30% return last year, but if that return was based on appraised values for non-traded assets, did it really make 30%? If your success is based on skill and not luck, you should have as open a process as possible for measuring returns and risk and allow investors to observe that process.
c. Awareness: If you beat the market, you are pulling off a difficult feat, since there are literally millions of investors attempting to to do the same thing. If it is not luck that is causing the superior performance, you have to be able to point to something that you are bringing to the table that others are not - better information, better analytical tools, a longer time horizon or a very different tax status. If you don't know why you are beating the market, rest assured that you will not be beating the market for very long..... In my experience, the most skillful investors tend to not only be the most self aware (of their strengths and limitations) but also have no qualms about letting you know what their investment philosophy is. (Note that you can be secretive about investment strategies but you give away little by sharing an investment philosophy).
d. Humility: This is my subjective input to the process. In my years in the market, I have discovered that it is the lucky investors (with no skill) who are most hot headed and arrogant about their skills, and that skillful investors recognize how much luck can affect their final returns.
Here is my bottom line for a skillful portfolio manager or CEO: I am looking for a person who has been able to deliver performance that beats the competition consistently over many years, can tell you why he or she can pull this off and is willing to concede that luck could explain the whole phenomena....
Update: A couple of you have drawn my attention to Mike Mauboussin's excellent and extended discussion of the topic.
www.lmcm.com/pdf/UntanglingSkillandLuck.pdf
Mike is one of my favorite thinkers in finance - he is always original and manages to think across disciplines - and I don't know how I missed this piece but he says what I was trying to say much better than I ever could, and in much more depth. Do read it!
As always in finance, there are two extreme outlooks. At one end, there are those who view any superior performance as evidence of skill and extended superior performance as almost super natural. At the other end, there are those who who contend that it is all "luck" and that portfolio managers have any "discernible skill". As an illustration, Fama and French have a damning article on active portfolio management, where they note that all of the excess returns in practice can be explained by randomness:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1356021
In their assessment, all "superior performance" in portfolio management can be attributed to luck. Here is a more recent paper by Andrew Mauboussin and Sam Arbesman that argues that there is some evidence of differential skill:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1664031
Needless to say, this is an issue where researchers have disagreed and continue to do so.
You may disagree with the broadness of the Fama/French conclusions (and I do), but they do point out how difficult it to differentiate lucky winners from skillful winners. To understand why, it is best to look at an arena where the differentiation between luck and skill is easier: sports. Even those who don't like Sachin Tendulkar, Lionel Messi, Tiger Woods or Kobe Bryant have to admit that they have skills the rest of us don't possess and that their success cannot be attributed to luck. So, why is it so easy to separate skill from luck in sports and not so in finance? Separating luck from skill is easiest when:
a. Success is clearly defined: In basketball, you either make a basket or you do not. In cricket, you are out or you are not. In golf, you make par or you do not. In soccer, you score a goal or you do not. An "almost a basket" or "almost par" can be a chatting point with a friend but does not count.
b. It is difficult to have a successful outcome with just luck: I will make a confession. I cannot shoot par on a golf course, make a three pointer in basketball or score a goal in soccer, even with luck. I am awed when I see people do these things, since I know it requires skills that I do not have.
c. Number of trials: Professional sports players get hundreds of chances to show their wares, and luck very quickly drops to the wayside. You may make one three-pointer in the gym, with sheer luck, but if you were asked to shoot a few hundred three pointers, your limitations would be clear to all. There is no way that luck can explain the hundreds of sub-par rounds that Tiger Woods had (when he was a golfer and not a celebrity), the runs that Sachin scored for India, the points (and championships) for Kobe and the goals that Messi has scored for Argentina (and Barcelona) over time.
Looking at finance through these lens, it is easy to see why it is so difficult to separate luck from skill:
a. Success is not clearly defined: Is a portfolio manager who makes money for his investors a success? What about one who beats the S&P 500 each year? Is a company that delivers returns that outstrip the rest of the sector a success a "good" company? The very fact that we have to think about our answers to these questions tells you something about "success" in finance. To be successful, you have to beat your benchmark, after controlling for risk. However, since risk is a subjective measure, it is entirely possible for a portfolio manager to be classified as a success by one evaluator and not by another. With hedge funds and private equity managers, it becomes even more so, since the net risk exposure is often tough to measure.
b. It is easier being successful with just luck in finance: I would not bet my house that my portfolio selections will deliver higher returns in the next year than those of my neighbor, who picks stocks based on astrological signs and has the financial sense of a dodo, or of my 11-year old son, who has never looked at the Wall Street Journal. As I note in my valuation class, there is no justice in the investing world. You can do everything right (collect the data, analyze it carefully, make reasoned judgments) and go bankrupt... and you can be absolutely cavalier in your investment judgments and make millions.
c. Too few trials: Can you be lucky once? Sure! How about 4 times in a row? Yes.. How about 15 years in a row? Not as easy, but with hundreds of people trying, a few will.... One problem that we face in portfolio management and corporate finance is that we get to observe outcomes too infrequently, making it difficult to separate luck from skill.
I don't mean to leave you in limbo. After all, most of us want to separate luck from skill in finance. So, here are the things that I would look for in a "skillful" portfolio manager or a CEO:
a. Consistency: As an investor, I don't want to just see that you beat the market, on average, but that you beat it consistently for an extended period. I am more likely to attribute your success to skill, if you beat the market by 2-3% each year for 15 years than if you beat the market by an average of 2-3%, with more variability and poor years intermixed, over that period.
b. Transparency: I tend to mistrust success, when that success is based on portfolio managers self-appraising the values of the properties and investments in their portfolios. A hedge fund may claim it made a 30% return last year, but if that return was based on appraised values for non-traded assets, did it really make 30%? If your success is based on skill and not luck, you should have as open a process as possible for measuring returns and risk and allow investors to observe that process.
c. Awareness: If you beat the market, you are pulling off a difficult feat, since there are literally millions of investors attempting to to do the same thing. If it is not luck that is causing the superior performance, you have to be able to point to something that you are bringing to the table that others are not - better information, better analytical tools, a longer time horizon or a very different tax status. If you don't know why you are beating the market, rest assured that you will not be beating the market for very long..... In my experience, the most skillful investors tend to not only be the most self aware (of their strengths and limitations) but also have no qualms about letting you know what their investment philosophy is. (Note that you can be secretive about investment strategies but you give away little by sharing an investment philosophy).
d. Humility: This is my subjective input to the process. In my years in the market, I have discovered that it is the lucky investors (with no skill) who are most hot headed and arrogant about their skills, and that skillful investors recognize how much luck can affect their final returns.
Here is my bottom line for a skillful portfolio manager or CEO: I am looking for a person who has been able to deliver performance that beats the competition consistently over many years, can tell you why he or she can pull this off and is willing to concede that luck could explain the whole phenomena....
Update: A couple of you have drawn my attention to Mike Mauboussin's excellent and extended discussion of the topic.
www.lmcm.com/pdf/UntanglingSkillandLuck.pdf
Mike is one of my favorite thinkers in finance - he is always original and manages to think across disciplines - and I don't know how I missed this piece but he says what I was trying to say much better than I ever could, and in much more depth. Do read it!
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