Yes, Your Favorite Money Manager Is Probably Just Lucky

Your favorite money manager has walloped the market by 5% per year for the past 10 years, so he's obviously a genius, right?

Actually, no. He had a one-in-five chance of doing that just by throwing darts.

Here's professor Ken French of Tuck, an advisor to Dimensional Fund Advisors, on the ease of mistaking luck for skill in investing:

People often misinterpret high average fund returns as proof that a manager does know how to identify pricing errors. Consider, for example, a hedge fund with an annual volatility of 20%. (To be more precise, the standard deviation of the fund's excess return with respect to the appropriate benchmark is 20%.) If the fund's average abnormal return is 5% per year over a ten-year period, many investors and financial reporters would conclude that the manager is truly gifted, with a real knack for identifying under- and over-valued securities. But they would probably be wrong.

Suppose the manager's true alpha is zero, so he really has no skill beyond that needed to recover his costs. If we pretend his returns are normally distributed, the probability that his average abnormal return exceeds 5% per year for a ten year period is more than 20%.

In other words, in a group of hedge fund managers with standard deviations of 20%, we expect one in five to have a ten-year average annual abnormal return of at least 5%--even if none actually have any skill. We expect one in twenty of the unskilled managers to produce a ten-year average annual abnormal return of at least 10%.

So your favorite money manager is probably just lucky. But, shhhh... Don't spoil the fun!

See Also: Why Hedge Funds Are Such A Great Business

Comments

[yappnmutt]

the interesting side of the study would be to measure the probability of doing worse than dart throwing. in other words, does one have to work at being a bad money manager?

[adoantarel]

And yet how much do these people take home in pay and bonuses?

[thenextguy]

That's why low cost index funds are the best way to go.

[Bobotheclown]

Yes, but how many hedge funds actually made over 5% for the last 10 years? Not 20%, not even 1%. Almost all hedge funds have been underwater some time in the last few years. Which means that they are performing worse than random. I guess you get what you pay for.

[HeevenSteven]

There used to be an economics reporter on NBC,, Jensen was his last name I think, who would meet with Malcolm Forbes every year and compare stock pics. Jensen would use all his savvy and Forbes would throw darts. It was a regular feature for a while.. can't remember anything about it except that throwing darts wasn't a bad way to go.

[drkazmd65]

As one of my old bosses always used to say,...

"If you have to chose between being good, and lucky,... always pick lucky."