A 2006 Fortune magazine article described Bill Miller as “one of the greatest investors of our time.”
At the time, the US$20 billion mutual fund that Miller managed had outperformed the S&P 500 for 15 straight years, a feat never before accomplished. If there was such a thing as an investment genius, it seemed like Miller was it.
Unfortunately for those who invested in Miller’s fund in 2006, it lost over 30 percent over the next five years. During that period, fund research firm Morningstar ranked Miller’s fund dead last among the 1,187 similar U.S. equity funds it tracked.
Did Miller change his investment strategy in 2006? No. For both the winning streak and the losing streak, Miller used the same strategy of focusing on stocks from a few large companies. Maybe Miller somehow lost his skill, or a key analyst left his team? Or perhaps the markets somehow changed?
Those things didn’t change. But what did change was Miller’s luck. It’s possible that both his success and his failure were due to luck, both good and bad.
Miller’s story points out an underlying truth about successful investing…
The thin line between good luck and skill
Let’s say that there’s a tournament to determine “the world’s greatest coin flippers”. 50,000 people from all over Asia are invited to a stadium. Everyone flips a coin at the same time.
After each coin flip, those who flip “tails” must leave, until the only people left in the stadium have flipped 10 consecutive heads. Basic statistics suggests that we could expect about 50 coin flippers to remain at the end of the contest.
Why? The odds of flipping heads 10 times in a row are (1/2)10 = 1/1024. So around one out of every 1,000 coin flippers would be left in the stadium.
On the back of their success, these 50 “skilled” coin flippers get millions of “likes” on Facebook. Their Twitter accounts blow up. Those with the best smile and social media skills will write bestselling ebooks about coin flipping. They’ll teach seminars for thousands of dollars a day about how to become a world-class coin flipper.
Maybe that’s an absurd example. But often, the performance of money managers is not much different.
Every year, the best performing fund managers are praised, and attract more clients because of their superior returns. Managers who beat the averages for 10, or even 15 years, like Bill Miller did, receive the most glowing accolades, and are hailed as geniuses.
The key is this: If money managers had no special skills, if their performance was entirely random (like the coin flippers), at the end of 10 or 15 years, there would still be a small number of managers with exceptional track records. Statistics say this has to happen. (And Bill Miller happened to be the lucky guy.)
So, even if a select few investment managers have rare skills that lead to amazing performance, it’s impossible to distinguish the skilled from the lucky by analysing performance.
And because it’s so easy to confuse luck with genius, investors tend to pile into top- performing funds. Anyone who understands mean reversion knows that extremely good performance, over any timeframe, tends to be followed by less spectacular results. Performance is mean reverting.
A consequence of confusing genius for luck is that investors tend to think it’s easy to be a successful investor. The ultra-successful, even though they are few, have an outsized effect on us. We believe we can succeed – because they did.
This tendency to base decisions on observed success, while ignoring unobserved failure, is called survivorship bias. Lotteries exploit the survivorship bias to rake in billions of dollars. Lottery ticket buyers are motivated by the stories of the few jackpot winners who become instant millionaires. The millions of ticket buyers who never win receive little attention.
We’re all familiar with the stories of day traders who made millions trading stocks from their living room table or the local Starbucks. These wildly successful traders even publish brokerage statements on their websites, and sell their strategies proclaiming that “you, too, can day-trade your way to riches.” Their success is highly visible, creating a strong impression that short-term trading can make you rich.
Meanwhile, none of the thousands of losing day traders have websites promoting their failures. The losers may have also had great trading plans, and were also aggressive and optimistic. But they were unlucky. It’s just that these numerous losers aren’t around to tell their stories, and nobody really wants to hear their stories anyway. It’s the few survivors we see that influence us.
The world of investing, like most things in life, produces success stories and failures. It’s human nature to wish to copy success. However, an ironic truth is this: To accept success at face value without acknowledging the role of luck is a strategy for failure.
Publisher, Stansberry Churchouse Research