Que Sera, Sera – The Role of Chance in Market Returns

This article was originally published on Quadrant Group’s website. Quadrant Group was acquired by Progeny in March 2017.

Investors spend too much money on expensive, actively-managed funds because they fail to sufficiently consider the influence of risk on the reliability of past performance. They see skill where none in fact exists and underestimate the role of chance in market returns. We all recognise the phrase “past performance is no guarantee of future returns”. For many years, financial regulators have made it mandatory on any type of promotional material that uses past performance to promote products. It’s there for a good reason. But apparently this warning does not have much impact.

“Investors underestimate the probability that a track record was generated by pure chance, especially in large fund populations and when fund managers take excessive risks”. This is a direct quote from a recent research paper, “Fooled by Randomness – Investor Perception of Fund Manager Skill”, by Professor Merkle et al. of the Department of Banking and Finance, University of Mannheim.

It seems that even sophisticated investors become overconfident about their ability to pick good fund managers and fail to recognise that league tables don’t add up to future performance. In fact, the picture is quite the contrary. The difficulty in assessing active managers based on past returns is two-fold. Firstly, people who rely heavily on forecasts seem to believe that skill plays a larger role in success than is statistically true. Secondly, if you consider the evidence, investors cannot systematically beat the market without taking on extra risk.

Spurious Tail

Market behaviour is riddled with false-positives. In his book, “Fooled by Randomness” which was the likely inspiration for the Mannheim study, Nassim Taleb uses complex statistics to make his point, but the logic behind his argument is simple enough: as the number of investment managers increases, so does the probability that some of them will outperform the market based on pure luck.

Taleb shows that chance plays a much larger part in life than most of us are willing to admit. 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. He states: “The idea is well known that as a population of operators in a profession marked by high degrees 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. The performance in the “spurious tail” is only a matter of number of participants, the base population of those who tried.”

Abstract: Assuming a symmetric market, if one has for base population 1 million persons with zero skills and ability to predict starting Year 1, there should be 500K spurious winners Year 2, 250K Year 3, 125K Year 4, etc. One can easily see that the size of the winning population in, say, Year 10 depends on the size of the base population Year 1; doubling the initial population would double the straight winners. Injecting skills in the form of better-than-random abilities to predict does not change the story by much.

This is quite paradoxical as we are accustomed to the opposite effect, namely that large increases in sampling reduces error. However, Taleb goes on to demonstrate that in the winner-takes-all market in which selection is then narrowed to past top performers, the statistical odds are far worse and the sampling error explodes.

If the lion’s share of investment is proportioned to a small number of managers, it’s obvious that the winner-takes-all effect causes distortions. Investors chasing the returns of top performers are statistically better off if they look at the entire population of fund returns rather than a biased selection which is likely to be the result of chance, not skill.

Even if there is such a thing as real stock-picking skill that enables a stellar manager to beat the market, at least by a little, on a semi-regular basis, they will still be overshadowed by the managers who’ve soundly beaten the market by sheer chance.

Flipping a Coin

What do you think the probability is of a coin that has come up heads for the past seven flips also landing heads up on the next throw? Well, it is 50% – the same as each of the previous flips. Taken in isolation, any fair coin toss must have a heads-probability of 50%. We all know this, yet when we have had 7 previous heads we intuitively think that the next toss must surely be a tails. A result of 8 heads in a row would be highly unlikely; nevertheless, looked at logically, you can see that the ‘unprecedented’ event of an eighth heads has already happened on each of the previous flips. A coin has no memory, so each flip has no effect on the next.

The same formula applies when more than one coin is used in calculating the chances. For each, the number of possible outcomes is raised to the power of the number of coins. Thus with one coin there were two outcomes (H,T) but with two coins there will be four permutations (HH, HT, TH, TT), with three coins, eight possible outcomes (HHH, HHT, HTT, TTT, TTH, THH, HTH, THT).

If you flip three coins the probability is three-eighths, or 37.5%, that only one coin will turn up heads (just count the number of times that only one heads occurs in the possible outcomes above).

But what about the chance of all three coins showing heads? This predictability is much less. There is only one TTT event, so the probability is one in eight or 12.5%.

Like flipping a coin, investment can only go up or down. Injecting skill in the form of better than random abilities to predict returns does not change the outcome by much. The efficient market hypothesis that has been around since 1966 still holds true. Investors cannot systematically beat the market without taking on extra risk. The results are clear from decades of research that top fund managers haven’t outperformed the market and statistically can’t do so by any substantial margin.

Risky Business

It’s easy to confuse luck with genius, which is why most investors make decisions based on past performance. However, this is not the only mistake investors make in picking funds. They also fail to appreciate that top performing funds take greater risks.

It’s tautological to say that if a company’s earnings and the valuations of those earnings are true then the return will be as expected. Investment risk comes into play when the possibility that one or both are lower. It’s impossible to know for sure what the future holds and it’s the nature of diverse outcomes that creates investment risk. Riskier investments are the ones where the eventual outcome of faring worse is more likely than sticking to safer investments.

London Business School Professor, Elroy Dimson, explained it well in his remark, “Risk means more things can happen than will happen”. Investors chasing top performers often overlook the extent that volatility skews returns. Their success may simply reflect the fact that they are essentially playing the lottery, putting their investments into very risky speculations.

You Don’t Always Get What You Pay For

Trying to pick one of the few winners is extremely difficult. While Taleb relies on the mathematics of probability to make his point, there is another reason for being suspicious of the top performers. They tend to charge a lot more for their services. The investment industry and the media tend to focus on fund performance. But the most reliable indicator of long-term investment returns is in fact cost.

Rule changes that took effect back in 2012, in the Retail Distribution Review (RDR), have improved adviser charges, simplified their structure and made them more transparent. However, active funds are still more expense than passive ones. A typical managed fund charges on average 2.74% per annum and of course, many charge more.

We offer clients much lower fees across our AstutePortfolios, with no hidden charges or surprises.

If You Can’t Beat’em

Taken together, managed funds essentially are the market. This means that collectively they hold their investments in pretty much the same proportion as a well-diversified passive fund. Therefore, on the whole they are likely to produce similar returns in the long term. Of course, as explained above, if you take costs into account the picture favours lower-cost portfolios.

To make the most of market returns, you must diversify by spreading your exposure to risk across variables such as security, geography and asset classes. The core of all our products includes an efficient return-generating mix diluted with low risk assets. Broadly this includes a mix of equity assets including property, which act as the return engine, combined with lower risk and inflation protecting assets. By diversifying our portfolios to minimise overall risk, we can ensure a stable return over time.

The future may not be ours to see but great investors master the possible outcomes by investing based on pure evidence. To learn more about how Quadrant Group can help you to manage your wealth, please get in touch.

This article does not constitute financial advice. Individuals must not rely on this information to make a financial or investment decision. Before making any decision, we recommend you consult your financial planner to take into account your particular investment objectives, financial situation and individual needs. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested. This document may include forward-looking statements that are based upon our current opinions, expectations and projections.

This article is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable but is not guaranteed.

Past performance is not indicative of future results and the value of investments can fall as well as rise. No representation is made that the stated results will be replicated.

Andrew Pereira

Director, Wealth

Andrew has been working with families, high-net-worth clients and business owners for well over 20 years.

Learn more about Andrew Pereira