Last month, we explored Jim Collins’ “Good to Great” suggestion that we would be well served by having a STOP-Doing List to pair with our To-Do Lists. For starters, we advised investors to STOP reacting to market noise and start heeding the long-term evidence. Another worthy addition to your financial STOP-Doing List is to stop picking active money managers (or hiring someone else to try to do this for you).
As a reminder, my definition of an active money manager is someone who is engaging in some form of forecasting, whether it be picking stocks, timing markets or a combination of both.
Predicting the Unknowable
In our personal and financial lives alike, we worry about so many things that we cannot control. One of the greatest of these things is the future. When speaking with investors about the dangers of trying to accurately forecast the market’s or a stock’s pricing moves, many can accept that it’s difficult to succeed on their own. But the next leap is harder to make. Most investors want to believe that, while they may not personally have the time, energy or expertise to beat the market, they can still turn to well-heeled professional managers to do the forecasting for them.
Financial Services Attracts the Best and Brightest
In most pursuits in life, more practice and more experience makes perfect. So if someone is really good at some occupation or trade, it is safe to assume he or she will continue to be good at it in the future.
However, active money management is different. The unique problem is that there are too many very smart and very talented money managers out there. All of these smart people equipped with the best research and best technology are competing with each other as they try to capitalize on the same opportunities.
The issue is not whether these opportunities exist; the more relevant question is whether a clever active money manager can profit from these opportunities, net of fees and costs and against enormous competition. Yes, there is a tiny minority who outperform the rest, but the real question is: Can you identify them in advance of their good performance, so you can be one of the few to benefit? We’ve posted this related Q&A to share some of the data on the tall odds active managers face in the quest to outperform their peers.
Money Manager Track Records: Luck or Talent?
Finding successful money managers who have out-performed in the past is as easy as looking up the results of last night’s hockey game. “Reading yesterday’s box scores”, as an industry colleague likes to say.
It is human nature and very tempting to assume that the strong past performance may foretell future success. Unfortunately, you cannot buy the past performance; all you can buy is the performance going forward. Chasing past performance is like the desire to hop on a fast-moving train. The faulty assumption people make is that hopping on board somehow gets you benefits from the previous part of the journey. As we all know, once you’re on board, it’s too late to capture any of the past success; you can only expect to reap future rewards. So there is a critical question you must ask about any existing stellar track record: Is it based on reliably persistent skill that will continue in the future, or is it simply luck that might go away at anytime?
The way to disentangle luck from skill is to apply statistics. Can you scientifically prove that a manager’s out-performance has been statistically significant? If you can, then you may have a case for it being skill rather than luck. The problem is, you typically need decades of data to gather the necessary stats … and by then it’s probably too late to help you. The money manager will already be retired or has moved on down the tracks to another venture.
This is why we encourage investors to STOP chasing hot active money managers and depend instead on steady-as-she-goes portfolios managed to go the distance in our capital markets.