A few weeks ago I had an argument with an acquaintance about Warren Buffett. Everyone in the financial industry goes on about his fabulous financial record and the skills he has used to create it.
But I have long wondered if it isn’t possible that Buffett is just a really lucky guy. After all, toss a couple of million coins 40 times and a few are bound to fall on heads each time. That’s the way probability works. Buffett’s record could be no more extraordinary than that of the person tossing the lucky coin.
It isn’t an argument that usually goes down all that well in financial circles. So I was pleased to see Matthew Vincent pointing out in the FT this week that it is entirely possible. You can read his column here: How fund managers get paid for winning the lottery. He sums up research from former pension fund manager Rick Di Mascio who, via his investment evaluation firm Inalytics, has shown that “there is a marked difference between the track record of a fund manager and his level of skill.”
Matthew also notes that out of 1,188 UK funds, only 16 have managed top quartile performance in each of the three years. And if you look at that with an eye on rational statistics, it is very hard to argue that that is the result of much in the way of skill. “Anyone with a rudimentary grasp of probability would know that a quarter of a quarter of a quarter must by definition be top quartile in all three years.” That’s 1.56% or 18 funds.
Those who aren’t convinced of all this and can’t be bothered to do the numbers need only remind themselves of illusionist Derren Brown’s attempts to explain probability to the general population via his TV programme The System which appeared to show that he had a guaranteed method of predicting the result of horse races. He didn’t of course. Wikipedia explains it here: “He had started by contacting 7,776 people and split hem into six groups, giving each group a different horse. As each race had taken place, 5⁄6 of the people had lost and were dropped from the system. Brown had a different person backing each horse in each race, and one individual, Khadisha, won five times in a row.” Khadisha was the only one the TV audience got to watch the whole way through.
What if Warren Buffett is Khadisha? One answer to that is that it doesn’t really matter – anyone who invested with him early on is now very rich, regardless of whether he is lucky or clever. The other is that it does matter. Why? Because most of us believe in fund manager skill and most of us are prepared to pay for it. But if we thought all success stories were just Khadishas, we probably wouldn’t.
I suspect most fund managers are well aware that their returns are more luck than skill driven. I spoke a few weeks ago to a stock-broking friend. He is keen to move to a hedge fund. Did he think he was particularly good at investing? No. Not at all. He can’t imagine himself making more than average returns. But if he is working at a hedge fund when a new bull market starts (as he thinks it will), he’ll be able to borrow lots of money and invest that too. Then his returns will look great and he’ll make a fortune. As he said: “average returns plus leverage, that’s where the money is.” Nothing to do with skill.