Sunday , 21 July 2024

What % of Your Portfolio’s Return Is Due to Skill & How Much to Luck?

An annualized average of 56% of all actively managed domestic equity funds, 59% of active U.S. large-cap equity funds, and 64% of active mid-cap equity funds underperformed broad-market indexes. [Index funds anyone? Let’s review.] Words: 895

So says Chris Gay, U.S. News & World Report, ( in edited excerpts from his original article*:

Lorimer Wilson, editor of (Your Key to Making Money!) and (A site for sore eyes and inquisitive minds) has edited the article below for length and clarity – see Editor’s Note at the bottom of the page. This paragraph must be included in any article re-posting to avoid copyright infringement.

Gay goes on to say, in part:

SPIVA (S&P Indices vs. Active Funds) measures the performance of actively managed funds against passively managed index funds, represented by relevant benchmarks. Over the 10 years that S&P has published them, SPIVA results show:

  • an annualized average of 56% of all actively managed domestic equity funds,
    • 59% of active U.S. large-cap equity funds, and
    • 64% of active mid-cap equity funds underperformed broad-market indexes.

Skill vs. Luck: Is There a Difference?

Which raises a question:

  • You might be paying your active fund manager for the exercise of skill, but how much of your portfolio’s returns are due to skill and how much to luck?

It’s a perennial question for which there is no clear answer, but it’s an important one to investors because of the way we size up funds and fund managers.

Most of us lean toward funds and managers with strong records, even though we’re always being told not to chase past performance. That bias toward previous success looks even less rational if it turns out that what we’re really chasing is not past performance but past randomness. How to know the difference?

The Bell Curve

Perhaps the first thing to understand is that active fund managers, like the rest of humanity, toil under the tyranny of the bell curvethat totemic, mound-shaped line on a graph whose peak represents average and whose tails represent outliers, whether losers (on the left) or winners (on the right). Over any time period, the vast majority of funds turn in performances that are somewhere in the fat part of the curve. The few who end up on the tails for some period almost inevitably get pulled back toward the median in subsequent periods, thanks to the phenomenon of “mean regression” so most long-term investors, who buy and hold funds for years (if not decades), will simply be pulled along as well, often paying hefty fees to their managers along the way.

The Efficient Market Theory

It’s not just mean regression that resists sustained out-performance; it’s the market, too. Efficient Market Theory, a concept developed by University of Chicago economist Eugene Fama in the 1960s, holds that in a market where all relevant information is available to everyone, prices always represent fair value and no one investor should get the chance to do better than investors overall.

True, the market is not always perfectly transparent. Even if it were, human biases often trump rational analysis, so there are moments when the market mis-prices some, if not all, stocks. The people who spot these “arbitrage opportunities” first, and most often, are the people who beat the market but are they, too, fate’s randomly selected outliers, like the first guy who happens to see a dollar someone dropped on the sidewalk?

Index Investing

A 2009 paper by Fama and Dartmouth finance professor Kenneth French argues that:

  • there’s no way to distinguish the impact of skill from the impact of luck and that
  • actively managed funds in the aggregate pretty much match the market before expenses, which means most fall short of the market after expenses.

That’s not to say there is no skill in investing, just that it’s relatively rare and hard to distinguish in the aggregate from the effects of chance. That’s one reason people get “fooled by randomness,” to reference a popular book, by Nassim Nicholas Taleb, about the hazards of underestimating the power of chance.

Happily, Legg Mason’s Michael Mauboussin, in an entertaining 2010 paper called “Untangling Skill and Luck,” provides a bit of clarity. “There’s a simple and elegant test of whether there is skill in an activity,” he writes. “Ask whether you can lose on purpose. If you can’t lose on purpose, or if it’s really hard, luck likely dominates that activity.”

It might seem these days like your fund manager has mastered the art of losing on purpose, but it’s highly unlikely. The same efficient market that prices prospective winners has already priced prospective losers, too. Short of mailing all your money to Bernie Madoff, it would be hard to manufacture a bad outcome in the market the way you might in, say, a round of golf with your prickly boss.

Unless you think Warren Buffett is just some guy on hot streak, you have to acknowledge that there is such a thing is skill in investing, and that some people have it but there’s a meta-skill at play here you’ll need if you’re the one making the decision to buy: identifying the people who have investing skill. For most of us, that’s about as difficult as finding successful companies—which is why we have index funds.

“Buy the market and hold it forever,” advises Vanguard legend and index-fund pioneer John Bogle in his latest book, The Clash of the Cultures, which laments the crowding out of investing by speculation over the past few decades.

“Don’t speculate on which manager may be lucky enough or smart enough to outperform the market for a time. Own an index fund, get a life outside of finance, and relax.”


Editor’s Note: The above post may have been edited ([ ]), abridged (…), and reformatted (including the title, some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. The article’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article.

Disagree? Concur? Have your say on the subject via:

We’d like to know what you have to say.

Related Articles:

1. Words of Wisdom From the Most Brilliant Investors Ever

There’s a bewildering amount of advice on how to invest…so it’s worthwhile, especially in today’s volatile markets, to take a look at what has actually worked, as opposed to what people claim works. We’ve collected some of the finest wisdom on markets from the most respected and successful investors, past and present. Words: 865

2. 12 Books that EVERY Financial Advisor – and Investor – Should Read

Bill Ackman, founder of Pershing Square Capital Management, believes the following books are essential financial reading. Enjoy the summer! Words: 235

3. Portfolio Down? Apply These Wise Sayings to Successfully Rebuild It

When the stock market reaches extreme levels of distress, the average investor – particularly those who have done their own research and made their own investment decisions – panic at seeing their savings diminish to such an extent. They often start questioning whether they should be making their own decisions and often their reaction is to salvage what is left and sell, sell, and sell some more. [Regretfully, that is not what one should do. Let me explain why that is the case and what you should be doing – NOW.] Words: 380

4. Value Investing: The Practical Application of Benjamin Graham and Warren Buffett’s Principles

5. Motivated Stock Pickers CAN Beat the Market! Here’s How

What hope can there be for motivated stock pickers – no matter how much they sweat and toil – to outperform the low-cost index funds that simply mechanically track the market? Well – in spite of the absurd rise of the Nobel-acclaimed, and highly promoted, Efficient Market Hypothesis that claims that individual investors can’t beat the market – it turns out there is plenty! Just ask Warren Buffett, for one. [Let me explain.] Words: 1574

6. Grow Your Portfolio to the Max! Here’s How

7. Should Stocks Be the Cornerstone of Your Portfolio?

There is a common notion that stocks, at least if held for a long-time, outperform other assets [and, as such,] should be the cornerstone of any long-term portfolio. [While that is indeed true,] it is best to focus first on how much you are able and willing to lose (i.e. what risk you are able and willing to bear) when determining the optimal allocation for your portfolio. [Only] then [should you] think about what potential investment returns you might be able to capture. [Let me explain.] Words: 1503

8. Words of Wisdom from Warren Buffett

9. Warren Buffett: Diversification is Nothing More Than Protection Against Ignorance