With a little bit of luck...

Imagine the scenario.  There are two fund managers, both of whom have demonstrated their expertise by producing well above average returns for their clients over the years.  In the late summer after much deliberation they both decide that Volkswagen shares would be an ideal addition to their respective funds.  They have made this decision having analysed the accounts, financial statements, projections and no doubt having meetings with senior management at the company.

Manager A makes their purchase at the beginning of September, but manager B decides to wait until they get back from holiday later in the month before going ahead.  You will be all aware of what happened next - out of the blue (exhaust smoke) 40% is wiped off the share price and while manager A is drowning their sorrows in a City hostelry, manager B is toasting their lucky stars by having another Pina Colada whilst swinging in a hammock!

Now, I do not intend to go into the morality of a company that deliberately installs a piece of software to cheat the system in millions of vehicles, but instead focus on the effect luck has on investment returns.

In this scenario manager A has used all of their experience before making this decision but an event that they would have no way of anticipating occurs and before you know it their performance relative to manager B is adversely effected.  However, does this make them a worse manager?  Of course not, but I bet a number of investors will be keener to invest with manager B in the future given they will have performed better this year.

There is no doubt that in the short term luck can have a far greater impact on returns than skill and experience.  In 2006 an American stock trading company asked ten Playboy playmates to each choose five different stocks to see how they performed over the next twelve months.  At the end of the experiment, five of the girls had beaten the index (and 90% of fund managers) with the top performer, Miss March 1998, achieving a return of 43% compared to the 13% increase in the S&P500.

Now, much as it might please some of our consultants to start holding meetings with playmates instead of fund managers, the returns these ladies achieved is purely down to luck and would be no different, although probably aesthetically more pleasing, than having Phil Taylor throw darts at a copy of the Financial Times and buying the shares in the companies where they landed.

So what can you do to try and remove the impact of luck and ensure that expertise has a greater impact on returns achieved?

Well focusing on long-term performance in measuring a manager’s ability is a good start.  The examples I have given show luck has a far greater impact on short-term returns yet 1 and 3 year performance league tables are still focused on, even though we would never suggest that anyone invest over so short a term.  In fact one company makes a great ballyhoo of publishing a list of “dog” funds that in the main is based on three year performance.

Ensuring that you have a spread of different managers with differing styles is another key factor in trying to get the odds in your favour as is investing globally as opposed to focusing solely on the UK.

However, undoubtedly the most important factor in trying to keep luck out of the equation is to keep your emotions in check and let your investments “run.”  Trying to guess markets is a quick way to the poorhouse as is constantly chasing performance, which as I have shown, in the short term, may well have been down to luck rather than good judgement.

As for Volkswagen, well their luck seems to have been exhausted!