Is it Genius or Luck?

 

A 2006 Fortune article described Bill Miller as “one of the greatest investors of our time.” The $20 billion mutual fund that Miller managed had outperformed the S&P 500 for 15 consecutive years, a feat never before accomplished. If there is such a thing as an investment genius, certainly Miller was it.

Unfortunately for those who invested with the genius Miller in 2006, the ensuing five years saw Miller’s fund lose over 30%. For the five year period after the Fortune article, Morningstar ranked Miller’s fund dead last among 1,187 US large cap equity funds tracked. 

What happened? Did Miller change his investment strategy in 2006? He did not. For both the winning streak and the losing streak, Miller used the same strategy of focusing on a relatively few large company stocks. Maybe Miller somehow lost his skill, or a key analyst left his team. Or perhaps the markets somehow changed.

Something clearly did change—Miller’s luck. It’s possible that Miller’s amazing success and his unlikely failure were all due to luck, both good and bad.

Miller’s story points out an underlying truth about measuring investment success — it’s very difficult to distinguish between good luck or bad luck, from skill or lack of skill.

Let’s use a fictional example to make the point:

Let’s say that Random Success Inc. sponsors a tournament to determine “the world’s greatest coin flippers.” 50,000 people are invited to a stadium. Everyone flips a coin at the same time. After each coin flip, those who flip “tails” must leave, until the only people left in the stadium have flipped 10 consecutive heads. I’m not a mathematician, but we would expect about 50 coin flippers to remain at the end of the contest. (The odds of flipping heads 10 times in a row are (1/2)^10 = 1/1024).

These 50 exceptionally “skilled” coin flippers get millions of “likes” on Facebook. Their Twitter accounts blow up. Those with the best smile and social media skills will write bestselling eBooks about coin flipping. They’ll teach seminars for thousands of dollars a day about how to become a world-class coin flipper.

An absurd example, to be sure. However, how different is the performance of money managers from this fictional tournament? Every year, the best performing professional investors are awarded praise, and attract additional client assets, based on superior returns. Managers who beat the averages for ten, or even fifteen years like Bill Miller did, receive the most glowing accolades, and are held up as geniuses.

The key is this: If money managers had no special skills, if their performance was entirely random, at the end of ten or fifteen years there would be a small number of managers with exceptional track records. It is statistically inevitable.

So, even if a select few investment managers have rare skills which lead to amazing performance, it’s impossible to distinguish the skilled from the lucky by analyzing performance.

And because it’s so easy to confuse luck with genius, investors tend to pile into top performing funds. Anyone who understands “mean reversion”, knows that extremely good performance, over any timeframe, tends to be followed by less spectacular results. Performance is mean reverting.

A consequence of confusing genius for luck is that investors tend to overweight the probability that they themselves will become rich via investing. The ultra-successful, even though they are few, have an outsized effect on us. We believe we can succeed -- because they did. This tendency to base decisions on observed success, while ignoring unobserved failure is called the survivorship bias. Lotteries exploit the survivorship bias to rake in billions of dollars. Lottery ticket buyers are motivated by the stories of the few jackpot winners who become instant millionaires. The millions of losing ticket buyers who continually waste their money receive little attention.

We’re all familiar with the stories of “day traders” who made millions trading from their living room table or the local Starbucks. These wildly successful traders even publish brokerage statements on their websites, and sell their strategies proclaiming “you too can day trade your way to riches.” Their success is highly visible, creating a strong impression that short-term trading can make you rich.

Meanwhile, none of the losing day traders—many thousands more—have websites promoting their failures. The losers may have had similarly well-conceived trading plans, were likewise aggressive and optimistic.  But they were unlucky. It’s just that these numerous losers aren’t around to tell their stories. It’s the few survivors we see that influence us.

The world of investing, like every business or endeavor in life, produces success stories and failures. It’s human nature to wish to copy success.  However, an ironic truth is this:  To accept success at face value without acknowledging the role of luck, to learn from only success, is a strategy for failure.

Mark Gaffney