Four hundred years ago Jacob Bernoulli had an insight that changed the world. As a result, today we benefit from wisdom that not only help us understand random events but allows us to exploit them for our benefit. Without the work of Bernoulli and those who followed him, we could not evaluate the efficacy of new drugs, we wouldn’t be able to insure anything, weather reports would be useless and Las Vegas would be a backwater railroad depot in the desert. I don’t think that it’s an overstatement that without the development of probability theory, modern life would be close to impossible.
The really fascinating thing, and the reason I’m writing this column, is that—despite the brilliance of Bernoulli and his followers; despite the benefits we have gained from their work—when investors are confronted with randomness they get so uncomfortable that they are willing to act as if it doesn’t exist. And I don’t mean a few Luddites—for starters how about just about everyone in the investment world? The following imaginary report to shareholders will sound outrageous only because you’ve never seen one, not because it isn’t a reflection of reality.
“Last quarter the ABC Value Fund’s net asset value grew by 17.6%, beating the S&P by over nine percentage points. Your investment team met last week to discuss the details of the quarter. We would have liked to report to you that the reason for the blockbuster quarter was our adept timing, our perceptive research, and our time-tested investment process. We indeed would have liked to say that. But we were unanimous in our agreement that the reason for the exceptional performance was just luck.”
Everyone understands that after all is said and done, performance is the single most important factor in investing—and benchmarking (comparing performance to a relevant index) is the primary tool we use to know we’re getting fair value for our risk. There’s just one problem: While the measurement of performance is accurate, it isn’t a complete description of reality.
In his book The Success Equation, Michael Mauboussin illustrates how the ratio of luck (randomness) to skill impacts the outcomes of various activities: In chess, for instance, the outcomes are almost all the result of skill; and in a lottery the outcomes are all luck. While difficult to quantify, the existence of randomness in investing is well documented, especially over the short term. In explaining how randomness impacts returns, Mauboussin writes: “A good process can lead to a bad outcome… and a bad process can lead to a good outcome.”
Taking this observation to its logical conclusion suggests that if randomness is really part of all investment returns, then performance measurement has limited value as tool for decision-making. Mauboussin offers us the following solution: “Since a good process offers the highest probability of a good outcome over time, the emphasis has to be on process.” This is sensible but it goes right up against our discomfort. Mauboussin may be correct in his analysis, but no one is going to care.
The very idea of randomness goes against our instinctual need to find a cause for every effect; making it close to impossible to identify or accept the influence of random events. Daniel Kahneman was awarded his Nobel Prize in part for demonstrating how pervasive this situation is, and how it misleads us in all kinds of ways. Investors are uniquely disadvantaged in this area; not only do we have to face our own internal obstacles, most of the investment industry ignores randomness like the plague.