The Adoration of Luck
We bestow fame and fortune on the elite group of money managers who have generated “outstanding” investment performance. They are featured in glossy business publications, their products command premium prices, and their words are taken as investment gospel. Indeed, one or two of them may be gifted, worthy of our praise, and even perhaps the riches we bestow on them when we agree to their fees. However, it is more than likely that we are taking advice from and paying fees to an elite group who are merely lucky.
|Investment Universe (1999)|
Here’s how it works. Imagine 5,000 people (portfolio managers) calling heads or tails as someone flips a coin in a game (the markets) where the winner advances and the loser goes home. After six coin flips, there will be 75 to 80 people who made all the right calls. If these people were stock or bond portfolio managers, Morningstar would bestow a 5-star rating on them; and if they managed private equity funds, consultants would recommend them. On the other hand, if these people won the lottery, we would not be interested in investing money with them, even though the portfolio managers and lottery winners share the same trait: good fortune.
For those investors who consistently place their money with the six-time winners, the results are likely to be worse than the average. The supposedly brilliant manager who “saw” the credit crisis coming and sold mortgages will not see the next twist in the financial road, and all his new investors will suffer as his returns revert to the mean or worse. Moreover, as investors clamor to give their money to the six-time winners, the “winning” managers have more money than they can possibly deploy in a productive manner, and the ensuing returns will be mediocre. The manager will, of course, be handsomely rewarded as his fees will have doubled or tripled before it’s clear that his luck has run its course. Of course, a few of the achievers will continue to perform well (someone who has called a coin flip correctly six times, has the same odds [50%] as he did on every previous toss), which increases our temptation to search for and back the next winner.
Of course, there probably are one or two managers among the “winners” who are truly gifted, but it’s almost impossible to tell the difference. The gifted and lucky will both bombard you with sophisticated marketing pitches and pearls of wisdom, so it is next to impossible to separate the gifted from the lucky. I don’t think individual investors can make the distinction, and I know that institutional investors are not any better. I believe it’s human nature to be attracted to these seeming winners, and so this game will persist.
What is particularly troubling to me is that we have come to worship this lucky elite in the world at large. While they certainly know something about money management, they don’t know more than the rest of us about social problems or government policy, and yet we seek their insight on a wide variety of subjects. The adoration of these folks is particularly damaging in our educational institutions, where all too many folks want to get in on the money management lottery. We would be better served if we confined our adoration to things worthy of high praise.