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Three Skills and Good Luck

12 January 2016

The efficient market viewpoint is right to emphasize that good performance results can be the result of luck, but not of skill.  However, every asset manager strives to get and to improve his/her investment skills. What is the investment skill, and how can we identify it? How can we distinguish between real skill and mere luck? We, asset managers of Eganov Asset Management Stocks&Derivatives Strategies, suppose that investment skill is one ingredient that keeps markets efficient. But the link between skill and investment returns is complicated.  Investment skill is not the sole driver of returns. It is one of several factors involved in the production of good returns. There can be good returns without investment skill, and there can be skill without good returns. Skills need to be constantly sharpened. The skilled asset manager can lose a link with the market or can experience difficulties adapting to new market conditions, business conditions or personal conditions.

To understand what is investment skill and how is it influenced by the good luck, let’s take coin-flipping as an example. Suppose, that we put 10 000 people in the stadium and gave them each a coin. Each person flips the coin 10 times. Most people will get a combination of heads and tails. But maybe one person will get heads 10 times in a row. If somebody flips 10 heads in a row, then we would not conclude that he has some skill. We would say he/she is lucky.  Now, suppose, we are studying a good 10-year performance of the hedge fund that stretches over a wide variety of market environments. In this case we can say it is the real skill, not just luck. It is tempting to assume the skill will persist and the good performance will continue. We assume that the investment skill is a missing link between the good results of portfolio manager and the future strong performance which we are waiting for. Unfortunately it might not be right. Past success won’t guarantee success in the future. We can’t tell ourselves:  if the performance is good, then  there is the skill to make the good performance in the future. According to market efficiency viewpoint, something is right when it doesn’t matter how long the performance continues. There is a theoretical possibility that the record manifests luck, not the skill.  And a roomful of monkeys could, in theory, have typed out buy and sell decisions that generated the performance record of Fidelity Magellan Fund and Berkshire Hathaway.

Peter Lynch ran the Fidelity Magellan Fund.  Warren Buffet manages the Berkshire Hathaway fund. They both have talent and skill for managing money.  Statisticians tell us, that a long-term history of performance is required to make a conclusion about the manager’s talent and prove that  he is not merely lucky. But such way of thinking misrepresents the problem, since the results will be collected more and more. As the track record gets longer and longer, thus acquiring more and more statistical significance, it may actually have less and less investment significance.  If you are exploring an exemplary track record covering 30 years, then you are likely looking at a record that is already too long! This performance began when the asset manager was, let’s say, 27. He is now 57. His asset management business has an amazing success, partially thankful to the great record, which has served as a magnet for additional assets.  He is incredibly rich and has several houses. He participates in political activity and charities. It goes without saying that we wish we had invested with him 30 years ago. We kick ourselves for not investing 10 years ago. But should we invest with him now? Maybe yes, but may not.  Specific risks arise around the exceptional investment performance. The major risks are: the risk of getting too defensive and the risk of getting too aggressive.  The first risk will be developed when the asset manager wants to protect his obtained performance. He or she loses his competitiveness and begins to enjoy his success. He/she trades carefully and tries to retain his or her performance which made him/her famous. Thus the exceptional manager becomes merely average.  The second risk will arise when the performance is so good that the portfolio manager becomes self-confidence and takes more risk which he would not have taken in the past. Eventually, the asset manager suffers a crash. Hence, if we define an investment skill as a sole factor of the good performance, then there is no skill because the sole factor of the good performance doesn’t exist. The good performance is a complex of the factors which interact between each other in different ways by different asset managers.

The asset managers often say that they would rather be lucky than smart. This adage takes attention to indefinite linkage between intelligence and performance. Sometimes, very clever people fail. Sometimes, the asset managers get the good performance which they did not seem to deserve. In order to create a list of factors which help to obtain the good performance, it is useful to ask why clever people often fail to produce good returns. When this happens, the basic failure is a failure of implementation, or execution of investment strategy. The execution of investment strategy can be broken down roughly into four different factors: focus, competitiveness, self-confidence and luck. This list of factors is not intended to be complete or definite. The object here is merely suggests some of the crucial factors that are quite separate from brainpower. Skill is the element most directly related to brainpower. How smart is the asset manager? Does he or she make independent market research or accept the researches from Wall-Street? Does he/she analyze the information in a unique way? Does he/she know the risk-factors his strategy and control these risks? Does the manager have realistic view on his market activity and the others investors? Brains are not enough. Sometimes smart people get lazy or distracted.

Focus is an manager’s ability to use his or her intellect to solve problems. Can the manager work in certain conditions which press down him or not? A list of background factors arises when analyzing the asset manager. They serve as warning signals to the experienced investor who is looking for an asset manager. Is the manager in a good health?  Is he or she going through a divorce?  Are the children OK?

Competiveness is the willingness to go extra mile, spend extra hour to achieve goals and good returns. The financial markets are ruthlessly competitive. If a money manager doesn’t approach to be the best then he or she shouldn’t play in the game at all. There are different kinds of competiveness. The best asset managers can control competiveness. This quality is important in the occurrence of two risks which mentioned above: the risk for additional protect of performance and the risk of self-confidence. The ideal money manager will have the control of his or her competitiveness, which is balanced out between two extremes. The competitive fires are still burning, but they are not burning brightly enough to create a new risk factor.

Self-confidence is the willingness of the asset manager to contrast his judgment against one of the others investors and against the whole market. Similar to competiveness, self-confidence has to be controlled. A good asset manager is always ready to revise his views in the light of new information and knowledge. Sometimes, the new information entails fundamental changes, for example: The company reports negative earnings, or the inflation number is worse than expected. Sometimes, the new information is simply information about what the market is doing. It helps for the prudent manager to make a conclusion that maybe he/she is wrong and the market is right. If the asset manager has no opinion, he has nothing to do. This category includes the extreme devotees of the efficient market viewpoint. They are so intimidated by the collective wisdom of the market that they no longer feel entitled to any valuation opinions of their own. Such managers invest only in the index funds or similar strategies. If the asset manager becomes too attached to her/his opinions, then she or he falls into a kind of intellectual stubbornness where he or she spends all the time fighting the tape.  The stubborn asset manager will lead to a crash. Never invest with anybody who has hard time admitting that he is wrong.

The final ingredient of the success is luck. We include luck οn the list to remind ourselves that investment success is a complicated process in which the final results reflect the interaction of a large number of factors, some of which lie totally beyond the control of the money manager. It may seem “unscientific” to include luck as an ingredient of the success, but, in fact, it would be unscientific not to include it. Luck is a part of life. The good things that happen to us are not always the result of our virtues, and the bad things that happen do not always flow from our vices. People who eat carefully and exercise regularly sometimes get sick for no reason at all. When we include luck as an ingredient of the success, we are not diminishing the importance of the other factors. At the same time we are not suggesting that luck is the most important factor, despite the theoretical possibilities suggested by the coin-flipping analogies.  Peter Lynch, Warren Buffett, George Soros, and other successful investors are smart, focused, competitive, and open minded. But luck serves its purpose.  You are lucky, if you have a track record for 10 years or you did not have a car accident and/or you did not have a heart attack. Bad luck could have intervened in many forms. If bad luck didn’t intervene, that was a good luck.

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