Nassim Taleb, New York University professor and author, speaks during the Bloomberg Markets 50 Summit in New York City, Sept. 15, 2011.
Mamas, don’t let your babies grow up to be investment professionals.
That’s the argument Nassim Nicholas Taleb, the investment expert and math whiz who wrote the influential book The Black Swan, is making these days.
In a brief paper with the blunt title “Why It is No Longer a Good Idea to Be in The Investment Industry,” Taleb argues that those breaking into the business, no matter how skilled, won’t be able to compete against “hot” managers whose supposed investing genius, and temporarily superior results, are the result of plain old dumb luck.
Taleb has been arguing for years that chance plays a much larger part in life than most of us are willing to admit – that we are, as the title of one of his books puts it, “fooled by randomness,” which we often interpret as being anything but random. And nowhere is this more evident than in the world of investing, because no one really knows how to predict where the market is going.
Taleb uses some fancy math to make his point, but the logic behind his argument is simple enough: The more investment managers there are out there, the greater the probability that some of them will outperform the market in a dramatic fashion based on nothing more than chance. As he puts it:
[A]s a population of operators in a profession marked by a high degree of randomness increases, the number of stellar results, and stellar for completely random reasons, gets larger. The “spurious tail” is therefore the number of persons who rise to the top for no reasons other than mere luck, with subsequent rationalizations, analyses, explanations, and attributions.
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Trouble is, these “subsequent rationalizations” can sound awfully persuasive. In hindsight, investing choices that paid off come to seem like genius moves, even if the fund manager making these choices is a complete idiot who happened to get lucky a few times in a row. This is a form of cognitive bias known as “outcome bias.”
Because it’s so easy to confuse luck with genius, investors tend to pile into top performing funds. Indeed, as behavioral finance researchers Brad Barber and Terrence O’Dean point out in a famous paper on the subject, more than half of funds purchased by investors are ranked in the top fifth in terms of past performance. Taleb explains what this means for managers:
Because of scalability, the top, say 300, managers get the bulk of the allocations, with the lion’s share going to the top 30. So it is obvious that the winner-take-all effect causes distortions.
Even if there is such a thing as real stock-picking skill that enables some to beat the market, at least by a little, on a semi-regular basis, the skilled will still end up playing second fiddle to investment managers who’ve soundly beaten the market through sheer luck.
Taleb’s explicit lesson is that going into the stock picking business is a bad idea, even if you have some modest ability in that difficult art.
But the implicit lesson of his paper, for investors, is this: Past performance really, really isn’t indicative of future results. Don’t chase performance, because chances are good that this performance is driven by luck, not skill, and that the performance of the “hot” manager of today will ultimately revert to the mean.
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Or worse. As a study by investment house R.W. Baird notes,
at some point in their careers, virtually all top-performing money managers underperform their benchmark and their peers, particularly over time periods of three years or less.
The lesson the folks at Baird draw from their research is that investors should stick with their fund managers through the rough patches.
But that’s not necessarily such a great move. Consider the story of fallen fund manager Bill Miller. Miller’s Legg Mason Value Trust fund famously outperformed the S&P 500 for 15 straight years from 1991 to 2006, making Miller look like a true genius. Then, meltdown: The fund dropped a cumulative 30% over the next five years, as Miller “doubled down on the likes of AIG, Wachovia, Freddie Mac, and Bear Stearns,” Frank Armstrong III notes in Forbes. “Boy that hurts!” Miller handed over the fund to his co-manager this April.
Does the fact that Miller outperformed the market for the improbably long period of 15 years mean there was more than luck involved when he was doing well? Not necessarily. If you have thousands of people in a room flipping coins, chances are good that someone will get “heads” 15 times in a row.
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While Taleb relies on the mathematics of probability to make his point, there are other reasons for being suspicious of “hot” managers. One is that they tend to charge more for their services, in the form of higher expense ratios.
The other is that their successes may simply reflect the fact that that they’re essentially playing the lottery with your money, putting it into especially risky investments. A recent journal article by economist Björn-Christopher Witte of the University of Bamberg argues that among fund managers “the Best Might be the Worst,” as the intense competition in the field pushes managers to take on ever greater risks in hopes of scoring big.
So maybe we should just stop picking stock pickers. If the performance of the hottest managers reverts to the mean in the long run, doesn’t it make sense to simply buy the mean – that is, to give up entirely on the notion of stock-picking genius and buy the whole market with an index fund?
It does, but a lot of us find it hard not to gamble by putting at least some of our money into the hands of fund managers who seem to have made a lot of smart picks. We all want to believe that we have an edge, if not in picking stocks than at least in picking those who will pick our stocks — even if in our heart we know it’s all an illusion.