Evaluating Luck or Skill in a Stock Picker

Investors choose fund managers based on their performance, says a recent article in The Wall Street Journal, but being able to evaluate stock picking skill is extremely tough.

This is the argument presented by Elm Partners co-founder and chief executive Victor Haghani, an advocate of index investing who asserts that the degree of confidence people have in their ability to pick “super-talented” fund managers is “surprising.”

Haghani, who co-founded the infamously defunct hedge fund Long Term Capital Management—which, the article says, “nearly took down the global financial system in 1998″—conducted some research to prove his point. He and two colleagues asked several hundred acquaintances that if he were to flip two coins, one of which was weighted to come up heads 60% of the time, how many flips it would take to figure out which one was the weighted coin. “Told to give a ‘quick guess’, nearly a third said fewer than 10 flips, while the median response was 40. The correct answer is 143.”

The test results, the article suggests, reflects the tendency for investors to “pay up” for managers they believe have the skill to beat an index, even though most active managers fail to do so. “Investors buy top-performing and top-rated funds without any ability to determine if skill or luck produced the gains. The result is that the typical investor in active funds lags behind even those funds’ returns by quite a bit,” the article says, concluding, “Coin flipping can get expensive.”