Professional investors are usually either skilled (informed) or incompetent (deluded), as explained in our classifications of financial market participants. But, can one demonstrate such skill or incompetence empirically?
In Paul Samuelson 1974 paper, “Challenge to Judgment”1, he questions the existence of money managers who can deliver superior performance. Interestingly, John Bogle, founder of The Vanguard Group, writes that this paper played a major role in precipitating the Vanguard 500 Index Fund’s creation.
Despite his scepticism, Samuelson writes:
”It is not ordained in heaven, or by the second law of thermodynamics, that a small group of intelligent and informed investors cannot systematically achieve higher mean portfolio gains with lower average variabilities. People differ in their heights, pulchritude, and acidity. Why not their P.Q. or performance quotient?”
Therefore, he admits that investing is not a pure game of chance. If it were, it would be impossible to outperform the market by applying one’s skill.
Proponents of the efficient market hypothesis believe that security prices follow a random walk. All available relevant information is reflected in a security’s price. New information arrives randomly. News is by definition unpredictable, else it is not news. So the price changes that reflect these news events are unpredictable. These price changes are seen as random departures from previous prices. See, for example, the explanation by Burton Makiel (2003)2.
Daniel Kahneman believes in this randomness as explained in his recent book “Thinking, Fast and Slow”3 and in an article he wrote for the New York Times. According to him, when it comes to stock picking ability, professional investors are suffering from an illusion of financial skill. He describes an experiment he conducted which illustrates this. He then concludes
“…. the evidence from more than 50 years of research is conclusive: for a large majority of fund managers, the selection of stocks is more like rolling dice than like playing poker.”
And also
“The successful funds in any given year are mostly lucky; they have a good roll of the dice. There is general agreement among researchers that this is true for nearly all stock pickers, whether they know it or not — and few of them do — are playing a game of chance.”
Even though Kahneman makes a strong case for almost no skill, he refrains from claiming there is no skill. If one only has evidence from examples, no matter how many, inductive reasoning cannot be used to make a general conclusion.
Unless one can show that
- there is not a single market participant with skill,
- after using all possible tests of skill,
no definitive conclusion can be reached. You can only claim that all swans are white once you are certain you have seen all swans.
The availability heuristic, described by Tversky & Kahneman (1974)4, is a bias that distorts the proper application of an inductive argument. It is a mental shortcut in which one draws only on familiar or immediate examples to form a judgement. With regards to the statement that security selection is a game of chance, there are indeed counterexamples, refer to Elton & Gruber (2011)5,. They summarise a selection of academic studies that have found some evidence of skill.
Note that skill and incompetence are two sides of the same coin. If financial markets follow a random process, then, likewise, it should be impossible to be an incompetent participant. As discussed before, incompetence can be exploited by skilful investors to generate outperformance. Long run track records of incompetent professional investors are, however, difficult to find, as it is highly unlikely that underperforming professional investors will retain their jobs and clients. So demonstrating incompetence among professional investors is even harder than showing skill.
So far, no consensus has been reached on the best statistical approach to proof skill or incompetence. We consider two approaches that can be used to test for skill.
There are apparently skilful investors or groups of investors with outstanding long run track records. However, these track records might be the result of pure luck. Therefore one approach is to show statistically that there is an extremely low likelihood of achieving such track records purely by chance.
An alternative approach is to demonstrate performance persistence. Consider an investor or groups of investors that have done particularly well over a set time period. Now if these investors are skilful they should do well again over the next or subsequent periods. If their subsequent performance is significantly better than what would have been predicted by randomness, then we can argue for skill.
These ideas will be examined further in future posts.
1Samuelson, Paul A. (1974). Challenge to Judgment. The Journal of Portfolio Management 1(1), 17-19. (Available here.)
2Malkiel, Burton G. (2003). The Efficient Market Hypothesis and Its Critics. Journal of Economic Perspectives 17(1), 59-82. (Available here.)
3Kahneman, Daniel (2012). Thinking, Fast and Slow, 212-217, London: Penguin Group. (Available here)
4Tversky, A., Kahneman, D. (1974). Judgment under uncertainty: Heuristics and biases. Science (New Series) 185, 1124-1131. (Available here.)
5Elton, Edwin J., Gruber, Martin J. (2011). Mutual Funds. SSRN Working Paper No 2088418, 41-47. (Available at here.)