Category Investments

Luck be a fickle lady – don’t indulge her when it comes to investments

20 March 2012 Madalet Sessions, Investment Analyst at Nedgroup Investments

: One of the biggest mistakes investors make when assessing investment performance is mistaking luck for skill. This is according to Madalet Sessions, Investment Analyst at Nedgroup Investments, who says that too often, investors, particularly when co

“Luck or unexpected events should not be a determining factor in long-term investment outcomes. While streaks do occur, they are rare.”

As such, she says it is worth remembering that even a run of truly exceptional performance by a skilled manager is unlikely to persist.

She refers to Michael J. Mauboussin, from Legg Mason Capital Management, who suggested that “the longest streaks should be held by the most skilful participants.” Stephen Jay Gould, a biologist and sports enthusiast famously summarised that; “long streaks are, and must be, a matter of extraordinary luck imposed on great skill.”

According to Sessions, the influence of news on portfolio stocks should also be viewed as the influence of luck. “News flow can influence markets and asset values in a variety of ways and is generally unpredictable. On any given day news can be good or bad, and better or worse than expected.”

Sessions explains that news, if better than expected will drive asset values higher, and if worse than expected will cause asset values to decline. She says one should think of this influence on portfolio values as the influence of luck. “Fortunately, luck is fickle. In statistical terms – the contribution of luck has an expected value of zero. Therefore, statistically speaking, the effect of luck, should be transitory and over the long run, outcomes should be determined by skill,” she says

She says rather, the focus should be on fundamental analysis - which includes identifying skilled business executives, macro-economic trends and business opportunities and how much of this is reflected in the price of the security.

“Having identified certain opportunities, a skilled manager allocates capital according to the attractiveness of the opportunity and the quality of the idea. By applying this skill with discipline and consistency, skilled investment managers display a greater tendency for outperformance as luck on its own (being fickle) is not sufficient to offset the influence of skill and sway the results. And sometimes, the stars align and extraordinary good luck and great skill combine to result in long streaks of outperformance,” she says.

According to Sessions, sustained success as an investment manager becomes a matter of outsmarting the crowd. She says as more and more skilled managers join the markets, it will become increasingly difficult to generate exceptional performance. “It’s known as the paradox of skill. To deliver exceptional returns, one needs to be smarter than the crowd. And if the crowd is getting smarter, generating exceptional returns become ever more difficult. As a result, most investors will earn market returns – and investments managers will appear to revert back to the average,” she says.

Sessions advises that in order to do better consistently, investors should carefully select skilled investment managers that maintain their advantage relative to the market. However she stresses the importance of sticking with these managers through periods of ‘unlucky’ underperformance.

“The danger in stressed economic periods is that investors could be tempted to invest with unskilled managers currently benefiting from a lucky streak. The focus should always be on consistent and long-term performance, as analysing the situation in isolation could turn out to be a very unlucky investment decision,” she concludes.

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