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Is It Luck or Skill?

Doesn’t it make you feel comfortable to live in an orderly and predictable world? Isn’t that especially true when it comes to investments? Haven’t you heard that the markets do not like uncertainty?

But isn’t it also true that the only constant in the world is change? In spite of that, our human brains have evolved to downplay the role of luck in our lives. That is why most investors like a financial plan that lays out the next 20 or 30 or 40 years of our financial lives. There in black and white, or more probably in a rainbow of colors, is the map of our financial future.

It is true that you and I like to look at the recent past and track record to project our financial situation into the future. Wouldn’t it be wonderful if it were that simple?

When I explain investing, I like to create an analogy to better illustrate investment track records of money managers. I think the best game to compare investing to is poker: unlike in other games, like chess or slots, it requires a combination of skill and luck. Think about it, experts always win in chess. Novices never beat the masters. For slot machines, novices and experts can expect to win at exactly the same rate. But in poker sometimes the novice beats the experts. It is a run of luck. Over the longer term however, the experts prevail in poker.

If you look at my results for the two types of accounts I manage, I believe you can see how skill and luck have played out. For AFC’s growth account, over the last 15 years having gone through the Great Recession and made it this far into the pandemic, the results show that for 15 ½ years the composite of my clients is beating the S&P 500 with dividends reinvested (see the graph below):

Past performance is no guarantee of future results.

Now check the Incentive Profit Sharing accounts. In five months the profit sharing account has turned $1 million into $2,033,945, a gain of 103% in less than 5 months. There was some skill involved in stock selection, both on the long side and short side. But the high return is due more to luck and the performance of stocks picked prior to the pandemic than skill in picking them I believed the long-term outlook in those stocks was very good, but the pandemic accelerated their growth dramatically. It is a return in five months I would not expect to be repeated. I do believe it will be statistically significantly better than the S&P 500 with less volatility.

This is why I believe the poker analogy is valid. Standard and Poors did a study of mutual fund managers that in 2017 showed that 63%  of large-cap managers, 44% or mid-cap managers, and 47% of small cap managers had outperformed the S&P Indices.[1] By the fifth year, only 16%, 15%, and 9% of money managers respectively could say they continued to outperform. By the 15th year, the numbers were down to 8%, 5%, and 4%.

Past performance is still no guarantee of future results.

Having been in the business for 34 years, I have so often seen advisors, mutual fund wholesalers, investment newsletters, and financial journals tout the “hottest” new fund or manager. It is not the last year that counts but the longer, ten-year track record that I believe can reliably showcase a money manager’s skill.

My profit sharing accounts have a very short track record. But the long market portion is the same as the growth accounts and I believe the short positions will enhance the returns. I chose two stocks in 2016 and two in 2019 that I believed had excellent possibility for growth because of changing technology, lifestyles, and demographics. (None of the stocks were the FAANGs). When COVID hit, three of the four stocks shot up. The pandemic has accelerated the lifestyle changes that I noticed were already happening prior to the pandemic. The pandemic was (from a certain point of view) the luck part which has pushed up the returns. Yes, there was skill in choosing those stocks, but the rapid ascent was due to luck.

In evaluating money managers, it is important to understand what is luck and what is skill. Skill makes itself apparent, I believe, in the longer-term track record. Luck shows in the shorter-term. Look again at the findings from Standard and Poors. There are numerous investment managers who develop a trading system or model or algorithm that works for two or three or even four years before collapsing. If you are evaluating money managers on their performance, look at the longer track record, not the short term. My track record for the growth account is already over 15 years. Sadly, the incentive profit sharing accounts have only recently become available due to changes in regulations. The base of the incentive profit sharing accounts is, however, the growth account portfolio. If regulations permitted it, I would put all my clients into the profit sharing accounts. After all, isn’t it the fairest way? Do not pay an advisor anything unless they make a profit for them. Doesn’t that make sense to you?

Mike Adams
President & Principal


[1] Soe, Aye M., CFA and Ryan Poirier, FRM, “SPIVA U.S. Scorecard”, S&P Dow Jones Indices (2018), https://www.spglobal.com/spdji/en//documents/spiva/spiva-us-year-end-2017.pdf.

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