Luck plays a far greater role than ability in whether an adviser beats the market.
Retirees are uniquely positioned to appreciate this, and to understand its investment implications. One of the wisdoms afforded by age is the recognition that the control our younger selves thought we had over life’s direction was largely an illusion.
This isn’t to say that ability plays no role in beating the market. But a healthy respect for the far larger role that luck plays is a key prerequisite for devising an appropriate retirement investment strategy.
Though many have tried over the years to measure the relative roles of luck and investment ability, one of simplest and most elegant comes from Bradford Cornell, a visiting professor of financial economics at the California Institute of Technology. The formula he derived keys off the insight that, over long periods, luck balances out. So by comparing the dispersion of short- and long-term returns, you can measure the role that luck plays. Cornell presented his findings in the Winter 2009 issue of the Journal of Portfolio Management.
Take a look at the accompanying chart, which is a scatter plot of investment newsletter returns over the trailing 1- and 20-year periods. Each vertical pair of dots represents a single newsletter’s returns over the two periods. Notice how the series of dots representing one-year returns is scattered all over the map, while the series representing 20-year annualized returns is confined to a fairly narrow range.
Since the two series reflect the same group of investment advisers, we know that investment ability is being held constant. The difference therefore must be caused by luck. When applying Cornell’s formula to the two data series in the accompanying chart, we can conclude that 91.8% of the advisers’ annual returns is due to luck.
It is interesting to note that this percentage is virtually identical to the proportion that Cornell derived when applying the formula to a large sample of large-cap mutual funds. This increases our confidence that the result isn’t just a fluke.
If anything, furthermore, Cornell’s formula underestimates the role played by luck. That’s because its implicit assumption is that luck plays no role in long-term performance. And though luck’s role is greatly reduced over the longer period, it’s still present.
But even if we accept at face value that 92% is a fair estimate of the relative role played by luck, the investment implications are still profound. Among the lessons retirees should draw:
•Though it is going too far to argue that ability plays no role in advisers’ annual returns, retirees are on safe ground behaving as though its role is negligible. That means you should focus your energies on asset allocation—the proper percentage to allocate to equities, bonds, alternative investments, etc.—rather than on trying to pick advisers that try to beat the market.
•If you nevertheless do want to follow an active manager in hopes of beating the market, you need to be willing to follow that adviser over many, many years. That’s because, over periods as short as a few years, odds are still very high that even advisers with genuine market-beating ability will lag behind the market.
•Your situation in this regard is not dissimilar to the odds facing a blackjack player. By being a shrewd card counter, you can perhaps increase your chances of winning a given hand to modestly above 50%—say 54% or 55%. While that’s impressive from a statistical point of view, it means that your odds of winning when playing a single hand are still hardly better than a coin flip. Only by playing many hands do your odds of coming out a winner become high enough to feel confident that you will leave the game with more money than you had when you started.
•One way in which this analogy breaks down, of course, is the length of each “hand.” In blackjack each hand might last a minute, but in investing each “hand” might last a year. The investment equivalent of a night of blackjack might therefore last a couple of decades.
•This required length of time is of particular concern to retirees, since their investment horizon could very well be shorter than what’s required to get the odds of beating the market arrayed in their favor.
•If, despite these formidable odds arrayed against you, you still want to try to beat the market, do so with only a small portion of your retirement portfolios. My advice in this regard follows the lead of the late Harry Browne, editor of Harry Browne’s Special Reports and, subsequently, the Libertarian candidate for president. He recommended forming two portfolios: The larger one will be a so-called “permanent” portfolio that you hold for the long term and rarely change, while the smaller, more speculative portfolio will be your play money. If this latter portfolio lags behind the market, which will be all too likely over the shorter and intermediate terms, its mediocre performance will not be devastating to your retirement standard of living.
The bottom line? Even when you’re fortunate enough to have picked an investment adviser with genuine ability, you may not be able or willing to follow that adviser for long enough to reduce the role played by luck to tolerable levels. Invest accordingly.
For more information, including descriptions of the Hulbert Sentiment Indices, go to The Hulbert Financial Digest or email firstname.lastname@example.org.