Can investment results be attributed to skill or luck?
Human beings are not cut out to be good investors. Instead of basing investment decisions on logic, data and evidence, people are much more likely to act on instinct, impulse and emotion.
An understanding of statistics is important for anyone providing investment advice. Lorica Partners uses statistical tools to assess the probability of investment outcomes and construct diversified portfolios that align with clients' financial goals.
Short-term movements in financial markets are essentially random; they tell us little or nothing about future returns. Although there is value in looking at returns over long periods of time, history doesn't repeat itself exactly; what happened in the past is only one of many possible future outcomes. From an empirical standpoint, therefore, it's helpful to think of numerous parallel universes of different outcomes drawn from the same underlying capital market process.
One of the reasons why most investors achieve suboptimal returns is they are too focused on time periods that are far too short. They assume, for example, that an active fund manager who has outperformed, say, for three or five years, will continue outperforming in the future.
Standard & Poor’s publishes a Persistence Scorecard to see what percentage of Australian active managers remain in the Top 50% of performers over five consecutive years. You may think this is not a high benchmark to overcome but look at the results:
The proportion of funds remaining in the top half of performers over five consecutive years was not better than 6% in any asset class, and smaller than would be expected if the performance were completely random (you would randomly expect at least 6.25% of funds to be in the top 50% for five consecutive years).
Almost no Australian funds, except for one Australian bond fund, remained in the top performance quartile (top 25%) within their category over five consecutive years ending December 2023.
Picking fund managers who you think are going to outperform is really hard. And here is the statistical evidence why.
A t-statistic is a wonderfully boring measure of statistical significance. It shows us how much or little weight to attach to a specific collection of data.
I'm not going to explain here how t-statistics are calculated (the formulas are visually terrifying), but you require a t-stat of 2 or more to be 97.5% certain that an active manager is genuinely skillful, or in other words, to confirm their performance is not simply down to luck. So how long a track record is required for a manager to obtain a t-stat of 2? Well, Index Fund Advisors in the U.S have run the numbers, and the answer is 127 years![i]
That's right, to be 97.5% certain today that a particular manager who actively trades publicly listed stocks has genuine skill, they would need a personal track record dating back to 1897!
If an adviser truly understands these realities, it should be unreasonable to recommend managers to their clients on the strength of just a few years of good performance.
Lorica Partners’ strategy for investing in public markets is supported by t-stats well above 2. Our approach is to start with the market, and then tilt the portfolio to buy more of those stocks with attributes that Nobel prize winning research shows have higher expected returns. Even this approach does not guarantee top quartile performance every year, but it is a low-cost, low-anxiety way of achieving the long-term investment returns our clients need to meet their goals.
Charles Ellis, an American investment consultant and lecturer at Harvard and Yale, explained it like this in his 1985 book Investment Policy: "The average long-term experience in investing is never surprising, but the short-term experience is always surprising. We now know to focus not on rate of return, but on the informed management of risk."
The informed management of risk is the guiding principle behind our investment process at Lorica Partners.
Lessons for investors
First, most periods you may think of as "long term" are really just fleeting moment full of noise.
Secondly, never extrapolate the recent past or draw conclusions from short periods.
Thirdly, look for a financial adviser who can help you to focus on your long-term goals and remind you of what the long-term evidence tells us whenever you feel tempted to change course. Low-cost, diversified funds have a place in every investor’s portfolio.
And finally, choose an adviser who really understands statistics and the probability of an investment solution delivering the returns you need to enjoy your best possible life.
Author: Rick Walker
Sources:
Does Your Financial Advisor Know What A T-stat Is? | Index Fund Advisors, Inc. (ifa.com)
Australia Persistence Scorecard: Year-End 2023 (spglobal.com)
[i] IFA calculation based on the average alpha (1.04%) and the standard deviation of that alpha (5.85%) among managers with 20 years (n=20) of returns data.