The Market Pays Luck as Well as Skill

Here are a few thoughts on luck vs. skill starting with today's Economist:

The lucky-take-all society 

Even those disturbed by rising income inequality accept the necessity of a system that rewards ability. And even the most die hard capitalist would not defend a system that apportions its rewards principally to the lucky. But what if talent and luck are increasingly hard to distinguish?

Alan Krueger, the departing chairman of Barack Obama’s Council of Economic Advisers, hit upon just that possibility in a speech in June, when he observed, “The lucky and the talented – and it is often hard to tell the difference – have been doing better and better, while the vast majority has struggled to keep up.”

The focus of Mr Krueger’s speech was the spectacular, and growing returns to superstars, in particular in rock and roll. He attributes the first explanation for superstar economics to Alfred Marshall:

In the late 1800s, Marshall was trying to explain why some exceptional businessmen amassed great fortunes while the incomes of ordinary artisans and  others fell. He concluded that changes in communications technology allowed “a man exceptionally favored by genius and good luck” to command “undertakings vaster, and extending over a wider area, than ever before....MUCH MORE

HT: FT Alphaville 

Last week in "Distinguishing Alpha from Noise" the Aleph blog makes the comment:

If your investments succeed for reasons that you specified in advance, that is an indication of skill.  There is a lot of what is called “luck” in investing.  If you are beating the market, and it is not for reasons that you specified in advance, you do not have skill, you have luck, and luck strongly tends to mean revert....

Now I am of the opinion that you can't be that dogmatic, that some people tend to position themselves where good things can happen, something that is difficult to specify in advance. Warren Buffet had a funny example of this in the 1984 Letter to Shareholders:

"...To earn even 15% annually over the next decade (assuming we continue to follow our 

present dividend policy, about which more will be said later in this letter) we would need 

profits aggregating about $3.9 billion. 

Accomplishing this will require a few big ideas - small ones just won’t do. Charlie Munger, 

my partner in general management, and I do not have any such ideas at present,

but our experience has been that they pop up occasionally. 

(How’s that for a strategic plan?)..."

From the 1985 Letter:

To the Shareholders of Berkshire Hathaway Inc.:

"...You may remember the wildly upbeat message of last year’s report: nothing much was in the works 
but our experience had been that something big popped up occasionally.

This carefully-crafted corporate strategy paid off in 1985.

Later sections of this report discuss (a) our purchase of a major position in Capital Cities/ABC, (b) our acquisition of Scott & Fetzer, (c) our entry into a large, extended term participation in the insurance business of Fireman’s Fund, and (d) our sale of our stock in General Foods. Our gain in net worth during the year was $613.6 million, or 48.2%. It is fitting that the visit of Halley’s Comet coincided with this percentage gain: neither will be seen again in my lifetime....."

The Cap Cities/ABC deal was one of BRK's (back then it was BKHT) ten greatest (See's Candies is still the best)

Moving along, from the Fama/French Forum at Dimensional Fund Advisors we have:

Fama/French: "Luck versus Skill in Mutual Fund Performance" (LMVTX)

...Are Winners Skilled or Lucky?
The fact that the aggregate portfolio of wealth invested in active mutual funds shows no evidence of manager skill does not mean no fund managers have skill. It simply means that if there are good managers who produce positive α, they must be balanced by bad managers who produce negative α. Can we find evidence of good and bad managers?...MUCH MORE

Knowledge@Wharton weighs in:

Gaming the System: Are Hedge Fund Managers Talented, or Just Good at Fooling Investors?

And finally, Dogbert the Hedgie:

Dogbert is, of course, a sociopath but that's his charm.
That and his little tail wag when is is especially pleased with a scam.
Most managers have only a vestigial tail.