Skilled managers do exist

(Published in the Financial Times on 27 January 2013)

John Authers asserts (Quest for test of investment skill persists, January 11) that nobody can tell which investors are more skilled than others and that active fund managers are unaware of their skills. 

These assertions are wrong. I suggest - with statistics on my side - that Berkshire Hathaway’s Warren Buffett and Renaissance Technologies’ Jim Simons are more skilled than most and furthermore that there are others who, with a little work, can be identified. I also know that at Aberdeen we are aware where we possess skill and - more pertinently - where we not.

Knowing where you possess skill however requires knowing what it is. Simply, investment skill involves identifying non-randomness in financial markets, then profiting from it. It is about knowing the difference between what is predictable and what is not. It is about understanding where and when one has an edge and then swooping in for the kill.

The sad fact is that the vast majority of investors waste their energies and capital guessing the equivalent of which side a coin will land, often supported by written and verbal justification that is both sincere and articulate.

The key to investing is knowing when the odds of a coin landing heads have increased to, say, 70 per cent or 80 per cent. And this is where serial mean reversion comes in. 

Occasionally, random walks take asset prices so far away from their mean or trend that they are pulled back towards it rather than continuing in a random fashion. If a coin lands heads 10 times in a row, the odds of a tail on the next throw are still 50 per cent. In the world of investing however, it may be 70 or 80 per cent. Put another way, despite the ubiquitous disclaimer, past performance can sometimes be a guide to the future.

Identifying pattern is very much what the two aforementioned maestros do in their own different ways. Mr Buffett’s edge, in my humble opinion, has been his remarkable understanding of human nature, both its strengths and its weaknesses, combined with discipline, patience, honesty and a very good grasp of statistics. Mr Simons, on the other hand, is a brilliant mathematician and has smarter and faster computers than anyone else. While Mr Buffett is the king of predicting share prices over 10 years, Mr Simons is unrivalled over 10 minutes.

Mr Buffett and Mr Simons are rare birds yet many still believe themselves to be good investors when the facts may tell a blatantly different story. The reason for this is that we humans evolved a survival mechanism to believe that we are better than we actually are. A timid approach to facing down a sabre-toothed tiger or attracting a cave mate would have been disastrous. Furthermore, we have an asymmetrical ability to blame our failures on (bad) luck but to attribute our successes to skill, a bias termed the fundamental attribution error. Thus you only need a couple of successes among all the failures to think you are a skilful investor.

If you have correctly identified an edge, the next step is to know how to use it. Question: if you have a biased coin that you know has a 6o per cent chance of landing heads and you are playing with someone who does not know the coin is biased, what percentage of your bankroll should you bet each round in order to increase your wealth over time?

If you bet nothing, you are wasting your edge and your wealth will remain the same. If you bet your entire purse, there is a 40 per cent chance the coin will come up tails, and you will lose everything and be out of the game (even with the bias, the chance of there being one tail in 10 tosses is 99 per cent.) So the optimal percentage must be somewhere between 0 per cent and 100 per cent. 

The answer, in fact, is 20 per cent. Bet 21 per cent or 19 per cent and over time you will end up less wealthy than if you bet 20 per cent. If you want to know the formula, google the term Kelly betting criterion.

How does this apply to investing? In Mr Buffett’s case, he of course understands that to put all one’s eggs in one basket is foolish, but also that being overloaded with baskets will wear you out. The efficient market hypothesis asserts that you should diversify as much as possible to eliminate stock specific risks. Mr Buffett on the other hand actively seeks out stock specific risk because he knows that is where his edge lies. As he has noted: Wide diversification is for people who do not know what they are doing.

Does Mr Buffett know precisely what his odds are? Of course not. What he does know is that he has a good feel for where a company will be in 10 or 20 years’ time, giving him the confidence to run a concentrated portfolio. There is much we can learn from him, though I am not the first to suggest that.