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Enrich Your Future 11: Long-Term Outperformance Is Not Always Evidence of Skill

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Quick take

In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 11: The Demon of Chance.

LEARNING: Don’t always attribute skill to success, sometimes it could be just luck.

 

“Just because there is a correlation doesn’t mean causation. You must be careful not to attribute skill and not luck to success.”

Larry Swedroe

 

In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over 30 years as the head of financial and economic research at Buckingham Wealth Partners to help investors. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.

Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 11: The Demon of Chance.

Chapter 11: The Demon of Chance

In this chapter, Larry discusses why investors confuse skill with what he calls “the demon of luck,” a term he uses to describe the random and unpredictable nature of market outcomes.

Larry cautions that before concluding that because an investment strategy worked in the past, it will work in the future, investors should be aware of the uncertainty and ask if there is a rational explanation for the correlation between the outcome and strategy.

According to Larry, the assumption is that while short-term outperformance might be a matter of luck, long-term outperformance must be evidence of skill. However, a basic knowledge of statistics is crucial in understanding that with thousands of money managers playing the game, the odds are that a few, not just one, will produce a long-term performance record.

Today, there are more mutual funds than there are stocks. With so many active managers trying to win, statistical theory shows that it’s expected that some will likely outperform the market. However, beating the market is a zero-sum game before expenses since someone must own all stocks. And, if some group of active managers outperforms the market, there must be another group that underperforms. Therefore, the odds of any specific active manager being successful are, at best, 50/50 (before considering the burden of higher expenses active managers must overcome to outperform a benchmark index fund).

Skill or “the demon of luck?

From probability, it’s expected that randomly, half the active managers would outperform in any one year, about one in four to outperform two years in a row, and one in eight to do so three years in a row. Fund managers who outperform for even three years in a row are often declared to be gurus by the financial media. But are they gurus, or is it just luck? According to Larry, it is hard to tell the difference between the two. Without this knowledge of statistics investors are likely to confuse skill with “the demon of luck.”

Bill Miller, the Legg Mason Value Trust manager, was acclaimed as the next Peter Lynch. He managed to do what no current manager has done—beat the S&P 500 Index 15 years in a row (1991–2005). Indeed, that could be luck. You can’t rely on that performance as a predictor of future greatness. Larry turns to academic research to test if this conclusion is correct.

In one example, the Lindner Large-Cap Fund outperformed the S&P 500 Index for 11 years (1974 through 1984). Over the next 18 years, the S&P 500 Index returned 12.6 percent. Believers in past performance as a prologue to future performance were not rewarded for their faith in the Lindner Large-Cap Fund with returns of just 4.1 percent, an underperformance of over 8 percent per annum for 18 years. After outperforming for 11 years in a row, the Lindner Large-Cap Fund beat the S&P 500 in just four of the next 18 years and none of the last nine—quite a price to pay for believing that past performance is a predictor of future performance.

In another example, David Baker’s 44 Wall Street was the top-performing diversified U.S. stock fund over the entire decade of the 1970s—even outperforming the legendary Peter Lynch, who ran Fidelity’s Magellan Fund. Faced with deciding which fund to invest in, why would anyone settle for Peter Lynch when they could have David Baker? Unfortunately, 44 Wall Street ranked as the worst-performing fund of the 1980s, losing 73 percent. During the same period, the S&P 500 grew 17.6 percent per annum. Each dollar invested in Baker’s fund fell to just $0.27. On the other hand, each dollar invested in the S&P 500 Index grew to over $5.

Belief in past performance as a predictor of future performance can be expensive

As evidenced by the Linder Large-Cap Fund and the 44 Wall Street Fund examples, belief in the “hot hand” and past performance as a predictor of the future performance of actively managed funds and their managers can be pretty expensive. Larry points out that, unfortunately, the financial media and the public quickly assume that superior performance results from skill rather than the more likely assumption that it was a random outcome. The reason is that noise sells, and the financial media is in the business of selling. They are not in the business of providing prudent investment advice.

Larry concludes that while there will likely be future Peter Lynchs and Bill Millers, investors cannot identify them ahead of time. Also, unfortunately, investors can only buy future performance, not past performance. A perfect example of this apparent truism is that in 2006, Miller’s streak was broken as the Legg Mason Value Trust underperformed the S&P 500 Index by almost 10 percent. The fund’s performance was so poor that its cumulative three-year returns trailed the S&P 500 Index by 2.8 percent annually. This further proves that it is tough to tell whether past performance resulted from skill or the “demon of luck.”

Remember that relying on past performance as a guide to the future might lead you to invest with the next Peter Lynch, just as it might lead you to invest with the next David Baker. That is a risk that a prudent, risk-averse investor (probably you) should not be willing to accept.

Further reading

  1. Karen Damato and Allison Bisbey Colter, “Hedge Funds, Once Utterly Exclusive, Lure Less-Elite Investors,” Wall Street Journal, January 3, 2002.
  2. Jonathan Clements, 25 Myths You’ve Got to Avoid (Simon & Schuster, 1998).

Did you miss out on the previous chapters? Check them out:

Part I: How Markets Work: How Security Prices are Determined and Why It’s So Difficult to Outperform

Part II: Strategic Portfolio Decisions

About Larry Swedroe

Larry Swedroe was head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.

Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.

Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.

Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.

Posted in Enrich Your Future, Podcast