Brains or bull market?

B. Venkatesh

Last week, I had an interesting discussion with two gentlemen about people’s faith in investment experts. If a professional money manager delivers higher-than-benchmark returns, we immediately presume that he is more skillful than the other managers. Is he?

You may choose a mutual fund that has performed well in the last five years. But there is a good chance that the fund will underperform the market in the future. Why?

Luck or skill

We do not know if that portfolio manager has beaten the market due to luck or skill. There may be so many variables that would have made the fund successful. The manager’s investment strategy need not be the only cause for it.

As one Hollywood executive put it, “If I had said yes to all the projects I turned down, and no to all the other ones I took, it would have worked out about the same.”

Of course, if the portfolio manager were to manage money for a really long time, we will then know if he has luck or skill. For it is argued that over the really long run, luck will run out and only skill will remain. Statisticians call this process ergoditicity.

Hot-hand effect

Psychologists have long studied our behaviour to see pattern in seemingly random events. One such study is the hot-hand effect. This essentially refers to the performance of a player during a particular match being far better than his normal record. Researchers found that if a player were to shoot three or four times in a row early in the game, the team would feed him through the match, thinking he had a “hot hand”. The study, however, showed that players do not have a “hot hand”.

Behavioural economists argue that is the same with portfolio managers. This is not to say that portfolio managers do not have skill. It is just that we may be unable to differentiate skill from luck. Or as the Wall Street adage goes “Do not confuse brains with the bull market”!

(The author is a self-styled investment psychologist. He can be reached at enhancek@gmail.com)

Sourced from: http://www.thehindubusinessline.com/