Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 29

Skilled managers do exist

John Authers of the Financial Times recently asserted 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 very much 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 keenly aware where we possess skill and – more pertinently – where we don’t.

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

Know when the odds are in your favour

The key to investing is knowing when the odds of a coin landing heads have increased to, say, 70 or 80%. 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 ten times in a row, the odds of a tail on the next throw are still 50%. In the world of investing however, it may be 70 or 80%. 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. Buffett’s edge, in my humble opinion, has been his remarkable understanding of human nature, both its strengths (what it takes to build a great company) and its weaknesses (propensity for humans to be greedy or to panic) combined with discipline, patience, honesty and a very good grasp of statistics. Jim Simons, on the other hand, is a brilliant mathematician and has smarter and faster computers than anyone else. While Buffett is the king of predicting share prices over 10 years, Simons is unrivalled over 10 minutes.

Buffett and 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 amongst all the failures to think that you’re a skilful investor.

Need to use your edge

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 60% 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’re wasting your edge (you know, he doesn’t) and your wealth will remain the same. If you bet your entire purse, there’s a 40% chance the coin will come up tails, and you’ll lose everything and be out of the game (even with the bias, the chance of there being one tail in ten tosses is 99%.) So the optimal percentage must be somewhere between 0% and 100%. The answer, in fact, is 20%. Bet 21% or 19% and over time you’ll end up less wealthy than if you bet 20%. If you want to know the formula, look up the term ‘Kelly betting criterion’.

How does this apply to investing? In 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. Buffett on the other hand actively seeks out stock specific ‘risk’ because he knows that’s where his edge lies. As he has noted, ‘Wide diversification is for people who don’t know what they’re doing.’

Does 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’s much we can learn from him, though I’ll admit I’m not the first to suggest that.

 

Peter Elston is Head of Asia Pacific Strategy & Asset Allocation at Aberdeen Standard Investments (formerly Aberdeen Asset Management).

 

RELATED ARTICLES

Unfortunately, all fund manager presentations are good

What game is your fund manager playing?

What types of people should manage your money?

banner

Most viewed in recent weeks

Vale Graham Hand

It’s with heavy hearts that we announce Firstlinks’ co-founder and former Managing Editor, Graham Hand, has died aged 66. Graham was a legendary figure in the finance industry and here are three tributes to him.

Australian stocks will crush housing over the next decade, one year on

Last year, I wrote an article suggesting returns from ASX stocks would trample those from housing over the next decade. One year later, this is an update on how that forecast is going and what's changed since.

Avoiding wealth transfer pitfalls

Australia is in the early throes of an intergenerational wealth transfer worth an estimated $3.5 trillion. Here's a case study highlighting some of the challenges with transferring wealth between generations.

Taxpayers betrayed by Future Fund debacle

The Future Fund's original purpose was to meet the unfunded liabilities of Commonwealth defined benefit schemes. These liabilities have ballooned to an estimated $290 billion and taxpayers continue to be treated like fools.

Australia’s shameful super gap

ASFA provides a key guide for how much you will need to live on in retirement. Unfortunately it has many deficiencies, and the averages don't tell the full story of the growing gender superannuation gap.

Looking beyond banks for dividend income

The Big Four banks have had an extraordinary run and it’s left income investors with a conundrum: to stick with them even though they now offer relatively low dividend yields and limited growth prospects or to look elsewhere.

Latest Updates

Investment strategies

9 lessons from 2024

Key lessons include expensive stocks can always get more expensive, Bitcoin is our tulip mania, follow the smart money, the young are coming with pitchforks on housing, and the importance of staying invested.

Investment strategies

Time to announce the X-factor for 2024

What is the X-factor - the largely unexpected influence that wasn’t thought about when the year began but came from left field to have powerful effects on investment returns - for 2024? It's time to select the winner.

Shares

Australian shares struggle as 2020s reach halfway point

It’s halfway through the 2020s decade and time to get a scorecheck on the Australian stock market. The picture isn't pretty as Aussie shares are having a below-average decade so far, though history shows that all is not lost.

Shares

Is FOMO overruling investment basics?

Four years ago, we introduced our 'bubbles' chart to show how the market had become concentrated in one type of stock and one view of the future. This looks at what, if anything, has changed, and what it means for investors.

Shares

Is Medibank Private a bargain?

Regulatory tensions have weighed on Medibank's share price though it's unlikely that the government will step in and prop up private hospitals. This creates an opportunity to invest in Australia’s largest health insurer.

Shares

Negative correlations, positive allocations

A nascent theme today is that the inverse correlation between bonds and stocks has returned as inflation and economic growth moderate. This broadens the potential for risk-adjusted returns in multi-asset portfolios.

Retirement

The secret to a good retirement

An Australian anthropologist studying Japanese seniors has come to a counter-intuitive conclusion to what makes for a great retirement: she suggests the seeds may be found in how we approach our working years.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.