Luck v. Skill

A big point of conversation in the financial media is the excellence of passive investing over active investing.  In other words, buying funds that mimic broad market indices is better than buying funds that actively pick stocks.  We disagree.

We think about the active versus passive argument constantly.  Are managers actually skilled or do they simply get lucky over a long period of time?  We believe that stock picking skill exists among the many active managers working in today’s market; however, finding them and investing with them is difficult and requires its own skill set.

It is odd to us that luck, when characterized in the financial media, only focuses on good. Said differently, “That investment manager only beat the market because they are lucky”.  It never seems to be, “That money manager underperformed because they are unlucky” rather it is, “That money manager underperformed because no one has the skill to beat the market”.  Remember, where there is good luck there is bad luck, where there is good skill their is no skill.  As it relates to picking investment managers, an adviser needs the ability to analyze based on both quantitative and qualitative factors.  While quantitative measures are easy to calculate (you can go to any reporting source and find performance, volatility, the Sharpe ratio, etc for any specific period time) the qualitative factors are much harder to define and analyze.  For instance, do they have an intelligent investment philosophy, do they have a rigorous process, are the people trustworthy?

A passive – index – strategy lacks the answers to these questions.  Since there is no one person making the decisions and process is usually straightforward and understandable.  Yet not every index is created equal and can vary in process, which seems to be lost on many investors.  They buy an index because of what it claims to hold and based on (we’re surmising) recent strong positive performance.  Indexation is not risk free. Simply because these strategies are highly diversified and have low fee’s does not automatically make them safe. Specifically, Wall Street sells recent past performance and they would have you believe that index strategies are the end all be all and only go up in value.  Simply because passive strategies have low fee’s and have outperformed active strategies over the last five years they cannot be beat.  We are trying not to get sucked into this marketing ploy. As much with any investment an investor needs to consider all risks (seen and unseen) prior to investing.  So, how do we sort the good from the bad?  We view our investment options through a probability lens.

Academics, commentators, theoreticians always seem to state that a manager outperforms due to luck and underperforms due to lack of skill.   They prove their points by measuring performance data.  They look for the data which support their predetermined conclusions. We don’t find the logic in this line of thinking. We don’t think this is the right way to go about it.  Instead, we aim to understand outcomes by grading them on a rubric.  For example, along the X-axis is the INPUT/PROCESS and along the Y-axis is the OUTPUT/OUTCOME.  See the matrix below.

 

luck v skill

 

Remember, investing is easy in theory, hard in practice.  It requires an ability to deduce the most likely manager that will do well in the future without subjecting an investor to an unnecessary amount of risk.  Just because an active manager has underperformed in the short-term does not mean they lack skill or have a poor process.  It may very well mean the portfolio is cheap and ripe for investment.  Future performance is dependent on many variables but recent past performance is not one of them.  This means anyone advising on fund selection must possess some level of skill in assessing fund attributes (its people, process, philosophy, etc).  It pays for investors to subjectively analyze an investment by looking forward and not solely relying on object past performance data.  It also pays investors to look long and hard for advisers with skill in selecting investments.

Adam Wright

About Adam Wright

Ever since I switched into the Smeal College of Business at Penn State I have pursued intelligent analysis with all the vigor available to me. Joining Wright Associates in 2011 has provided me the opportunity to put years of education to work.