In 2006, Fortune magazine described Bill Miller as "the greatest investor of our time."
Miller managed a $20 billion mutual fund, the Legg Mason Capital Management Value Trust, that had outperformed the S&P 500 Index for 15 straight years, a feat never before accomplished. If there is such a thing as an investing genius, Miller – it appeared – was it.
But unfortunately for those who invested in Miller's fund in 2006, his fund lost more than 30% over the next five years while the S&P 500 gained 15%. Fund research firm Morningstar ranked Miller's fund dead last among the 1,187 similar U.S. equity funds it tracked over the period.
What happened? Miller's investment strategy didn't change... Throughout both his winning streak and his losing streak, Miller used the same strategy of focusing on stocks from a few large companies. Maybe Miller somehow lost his skill, or a key analyst left his team? Or perhaps the market conditions changed?
Those things didn't change. Miller's luck changed. It's possible that both his success and his failure were due to luck, both good and bad.
Miller's story points out an underlying truth about successful investing — that it's very difficult to distinguish between good luck and skill, or bad luck and lack of skill.
Heads or Tails
Let's say that we sponsored a tournament to determine "the world's greatest coin flippers." The 50,000 competitors from all across America are invited to a stadium, where everyone flips a coin at the same time.
After each coin flip, those who flip "tails" must leave, until the only people left in the stadium have flipped 10 consecutive heads. Basic statistics suggest that we could expect about 50 coin flippers to remain at the end of the contest. (The odds of flipping heads 10 times in a row are about 0.1%. And 0.1% of 50,000 is 50.)
Then, these 50 "skilled" coin flippers go viral. They get millions of "likes" on Facebook. Their Twitter accounts blow up. They're the world's most talented coin flippers! Those with the best smile and social media skills will write bestselling e-books about coin flipping. They'll conduct seminars for thousands of dollars a day about how to become a world-class coin flipper.
Maybe that's an absurd example. But often the performance of money managers isn't that different.
How Outperformance Happens
Every year, the best-performing fund managers – here we're talking about actively managed funds, not passively managed ones that track an index – are touted as brilliant and attract more investors because of their superior returns. Managers who beat the averages for 10, or even 15 years, like Bill Miller did, receive the most glowing accolades and are held up as geniuses.
The key is this: If money managers had no special skills, if their performance was entirely random (like the coin flippers), at the end of 10 or 15 years, there would still be a small number of managers with exceptional track records. Statistics say this has to happen... just like there will be a small number of exceptionally talented coin flippers.
So, even if a select few investment managers have rare skills which lead to amazing performance, it's difficult to distinguish the skilled from the lucky simply by analyzing performance.
Mean reversion suggests that extremely good performance, over any timeframe, tends to be followed by less spectacular results.
One consequence of confusing genius for luck is that investors tend to think it's easy to be a successful investor. The few ultra-successful have an outsized effect on us. We believe we can succeed because they did.
Beware This Bias
This tendency to base decisions on observed success while ignoring unobserved failure is called survivorship bias. Lotteries exploit the survivorship bias to rake in billions of dollars. Lottery ticket buyers are motivated by the stories of the few jackpot winners who become instant millionaires. The millions of ticket buyers who don't win receive little attention.
Similarly... day traders or crypto bros who make millions out of pocket change get lots of airtime, while we rarely hear about the millions of speculators who lose their shirts. The losers may have also had great trading programs and were also aggressive and optimistic. But they were unlucky. It's just that these numerous losers aren't around to tell their stories, and nobody really wants to hear their stories anyway. It's the few survivors we see that influence us.
The world of investing, like most things in life, produces success stories and failures. It's human nature to wish to copy success. An ironic truth is this: To accept success at face value without acknowledging the role of luck is a strategy for failure.
How to Distinguish a Real Winner
Back to money managers... if performance isn't necessarily a reliable indicator of long-term success, what is?
One solution is to focus on process, as well as performance. In its writeup of Bill Miller, Fortune magazine (inadvertently) flagged a looming issue...
Miller's group is just as likely to be discussing the functionality of ant colonies or river systems as P/E (price-to-earning) ratios. The man runs a required book club for his investment team... Miller is chairman of the Santa Fe Institute, a think tank founded to study complexity, for goodness' sake. "The depth and breadth of Bill's intellect is pretty amazing," says Robert Hagstrom, who works as a portfolio manager at Legg Mason... The fact is that Miller has spent decades studying freethinking overachievers, and along the way he's become one himself.
"What we are really trying to do is to think about thinking," Miller [said].
If that sounds like a self-adoring money manager who has drunk a bit too much of his own I'm-so-wonderful Kool-Aid... go with your gut. Stock selection and managing a portfolio entails hard work and rigorous analysis – and as soon as it veers into other lanes of analysis that sound kind of hokey, buyer beware.
July 14, 2022
Editor's note: The best investors do the hard work through research and due diligence, they're focused and controlled, and they know their objective. But most folks just don't have the time.
So next week, Doc Eifrig will share the biggest financial opportunity of his career. It's one of the surest things he has ever seen in the financial world and it's already happening now.