Investment management is certainly a challenging field. On a daily basis, many variables affect securities prices and the value of investment portfolios worldwide. Certainly no one individual possesses a crystal ball that can predict the future.
Warren Buffett, who is affectionately dubbed “The Oracle of Omaha,” will readily admit even he cannot accurately predict future market events. However, Buffett has managed to outperform the stock market by a wide margin, joining the few investors who have. However, what is the contributing factor to this outperformance? Is it actual skill, or just luck?
John Rogers of Chicago-based Ariel Investment Trust presents an interesting illustration on this topic. He states that the best test of any activity where skill is rewarded is the extent to which a participant can lose on purpose.
For example, a chess grandmaster will outclass a beginner almost every time, but could choose to play badly enough to lose to anyone. By contrast, it would be impossible to lose every time at a slot machine, because the outcome is determined strictly by luck.
Rogers decided to test this skill v. luck theory as it pertains to investment management, and asked 71 of his staff members to pick 10 stocks that would underperform the market for the second quarter of 2009.
Only 19 succeeded, meaning 73 per cent tried to lose on purpose but failed. The average return of the “loser” picks was 30 per cent, compared to a total return of 15.93 per cent for the S&P 500 index. Thus, if one can’t lose on purpose, then winning must also be due to luck.
For decades academics have argued that stock markets are efficient. That is, securities prices reflect all public information, and that future price movements will be determined by random and unpredictable future events. Thus, trying to identify mispriced securities and get a “deal” on stocks is a futile task.
Over longer periods, we continue to observe indices outperforming the majority of domestic funds. In three- and five-year periods, only 12.5 per cent and 7.4 per cent, respectively, of actively managed Canadian equity mutual funds have outperformed the S&P/TSX composite index.
The implications of that are:
1. Some mutual funds will outperform the market mostly due to luck; thus
2. Don’t waste time trying to identify lucky money managers; if you want market returns, just buy the market index.
Investors are certainly getting on board with this idea — investment in exchange-traded funds or ETFs, which are mostly passive investments that track stock market index returns, is growing. Canadian ETF assets have increased to over $30 billion. This represents a 29.6-per-cent growth rate over the last five years. By contrast, mutual fund assets, most of which are traditionally managed products, have only grown 5.6 per cent over the same period.
What does the Oracle of Omaha say? From his chairman’s letter in the Berkshire Hathaway Inc. 1996 annual report: “Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees.”
Probably the best investment advice he has given yet.
Alan Acton is a financial adviser in Ottawa and can be reached at firstname.lastname@example.org. The opinions expressed are those of Alan Acton and not necessarily those of Raymond James Ltd. Statistics, data, and other information are from sources believed to be reliable but their accuracy cannot be guaranteed. This document has been prepared to assist individuals with financial concepts and is for informational purposes only.