Investing Strategy Is a Chancy Business

In the investment world, it’s all about the results. Despite evidence to the contrary, it is much simpler to pin over-performance or under-performance (the effect) on the investment manager (the cause). But the impact of that decision has perverted incentives throughout the investment world, and led investors and managers alike to operate in an Alice in Wonderland reality.

David Tuckett is a London-based psychoanalyst and academic. Six years ago, he interviewed 52 top investment managers in Europe, North America and Asia and published his findings in a small book called Minding the Markets. His subjects were experienced and successful investors at the top of their game. In aggregate they managed over $500 billion in equities. In the course of his interviews Tuckett discovered an unexpected common denominator among his interviewees: They could not execute the long term strategies they knew would be successful—because the pressure to look exceptional over the short term was just too intense. Whether it was fund investors, institutional clients or their own employers—the managers understood that their continuing employment depended upon them outperforming both long-term and short term: an outcome they knew was impossible to achieve.

The managers’ concerns are real. The dominant reason even sophisticated investors choose to hire an investment manager or buy a mutual fund is performance, especially recent performance. A 2008 study of large pension plans showed that nearly all the 9,000 hiring decisions and half the 870 firing decisions were based on performance. Further studies demonstrated that investors gained no benefit from firing one manager and hiring another. Because randomness is part of all returns, those returns act according the law of reversion to the mean.

If you are flipping coins (a completely random activity) and you start with 10 heads in a row, everyone knows that as long as you keep flipping, at some point the results will revert back towards the ultimate 50/50 average (also known as the mean). Reversion to the mean is really that simple; and furthermore, it can’t even occur unless there is randomness.

The recurring observation of reversion to the mean in investment studies proves the existence of randomness in portfolio returns. That is how we can conclude with reasonable certainty that the reason why a good manager is outperforming is not a reflection of suddenly better skills—and the reason why a good manager is underperforming is not a reflection of suddenly worse skills; it’s just a run of good or bad luck. It is also explains why firing underperforming managers and replacing them with outperforming managers does not produce a better return than if investors just stick it out with their original manager.

Let’s review: It is an indisputable fact that randomness exists in all investment returns. Thanks to probability theory we have a robust and successful tool-set to understand and exploit that randomness for our own benefit. And we can see that performance measurement gives us a useful but incomplete picture of how we are doing; so we need to supplement that data with an evaluation of the process of the investment manager. None of these observations are either new or controversial. Yet benchmarking remains the core paradigm for hiring and firing of funds and managers—and is likely to remain so indefinitely.

Navigating past the perverse incentives that infect the investment world and our own instinctual shortcomings is no simple task. But we can still be confident that we can make good choices if we remind ourselves that every outcome in life is the result of the combination of two basic elements: skill and luck.