by Olivier d'Assier
Three portfolio managers walk into a bar (none of them are German, French, or Clerics – it’s not that kind of joke). They order a drink, hoping a beer ‘pints’ a thousand words, and take turns pitching their mutual fund to the patrons. The first one says “Over the last three years, I’ve beaten the benchmark by 3%, putting me in the top ten percent of fund managers”. The second one says “In the last three years, I have never underperformed the benchmark by more than 5%, making me one of the safest managers during that period”. The third says “my investment process has a greater-than 60% probability of outperforming the benchmark by at least 1.5%, and a 90% probability of capping potential active losses at less-than 10%”. Which one do you think should gather more assets?
An investor may have a high level of investment skill but perform poorly because he does not conceive of investing as distinct from gambling. No further cultivation of investment theory will remedy this problem. Conversely, a successful investor may have inferior investment knowledge, but a firm grasp of concepts such as probability and confidence intervals that lie at the heart of the activity.
The first manager above should not gather much assets – there is ample evidence in the literature that past performance is no indication of future performance[1]. But, greed and memory never were on speaking terms, so she may get a few gamblers among the DINKs[2] in the crowd looking for a new punt to make a quick buck.
The second manager was trying to appeal to the timid investor hoping to dab his toes in the market without losing a foot. It’s a pitch for the pessimist – who the hell (pardon my French) invests solely on the basis of how much they could lose!? Still, the few paranoid SITKOMs[3] in attendance that day may identify with that kind of opportunity. My guess is this manager was never a ‘has-been’; probably a ‘never-was’.
The third manager, on the other hand, was talking directly to the probability-astute investor by providing the odds that would allow her to form a mathematical picture of what the fund’s future performance should look like, as well as what would represent abnormal returns. The simple fact of defining the return distribution for the investor will allow them to formulate an informed judgment about its suitability with regards to their own investment goals and risk aversion level. It focuses the investment decision on the future rather than the past, and speaks directly to the concept of repeatability rather than history.
In my latest paper, “What are the Odds?”, I describe the link between high-level risk statistics and probability theory as it applies to investment choices. Gamblers only focus on returns. Savvy investors focus on probability-adjusted returns and invest only when the odds are in their favour.
[1] So much so that fund managers are obliged to state that past performance is no guarantee of future performance in their fund’s literature!
[2] DINK: Double Income No Kids
[3] SITKOM: Single Income, Two Kids, Outrageous Mortgage
