Highlights.

  • It’s not uncommon for active investors to outperform the stock market. But they often have to take on greater risk to do so. 
  • It’s nearly impossible to say with certainty whether the cause for a stock trader’s superior performance was luck or skill. 
  • Sensible, rules-based investment strategies offer the best chance for actively managed portfolios to lessen drawdowns in bear markets, and thereby generate alpha.

In war, strategy is not always the determining factor of whether a battle is won or lost.  Rather, a general’s success can oftentimes be attributed to a stroke of luck.  One example: on September 13, 1862, a Union corporal — Barton W. Mitchell of the 27th Indiana — found three cigars wrapped in a piece of paper lying in the road.  The paper turned out to be “Special Order 191”, which laid out General Lee’s plans for the invasion of the North.  This information was sent to Maj. Gen. George B. McClellan, the commander of the Army of the Potomac, who used the information to halt Lee’s advance at the Battle of Antietam.

When Napoleon Bonaparte was criticized for winning battles simply because of luck, he responded: “I’d rather have lucky generals than good ones”.  More than a hundred years later, Eisenhower concurred; “I’d rather have a lucky general than a smart general”.  Eisenhower said “They win battles”.

Jason Zweig recently wrote an article for The Wall Street Journal discussing whether it’s reasonable to expect a portfolio that is actively managed to outperform a portfolio of passively managed index funds, which continue to attract investments at an astounding pace.  As Mr. Zweig’s article notes, Morningstar estimates that for 2018 through November 30th, investors have withdrawn $142 billion from actively managed U.S. equity funds and have contributed $184 billion to U.S. index-tracking stock funds.

Mr. Zweig’s article discusses legendary economist Paul Samuelson, who is one of the giants of quantitative finance.  According to Wikipedia, when awarding Professor Samuelson the Nobel prize in economics in 1970, The Swedish Royal Academies stated that Professor Samuelson did “more than any other contemporary economist to raise the level of scientific analysis in economic theory”.

Professor Samuelson is often credited for kick-starting the passive investing movement.  He once said, “Investing should be more like watching paint dry or watching grass grow.  If you want excitement, take $800 and go to Las Vegas”.  Nonetheless, he himself made a fortune on his investments in Berkshire Hathaway, which has been actively managed for decades by Warren Buffett and Charlie Munger.

Was Professor Samuelson’s decision to invest in Berkshire a matter of luck or skill?  As Mr. Zweig’s article explains, Professor Samuelson’s investment in Berkshire Hathaway was driven by his belief that Mr. Buffet and Mr. Munger are members of a very elite group: highly-skilled, patient, investors whose superior intellect allows them to outperform the market by investing in individual companies.

Is it uncommon for an active investor to outperform a passive portfolio?  No, in fact, it happens all the time.  If it didn’t, then the stock market could not function as it does.  However, when comparing the performance of passively and actively managed portfolios it is important to keep in mind:

  1. There are so many different types of active investment strategies that it is a gross over-generalization to refer to them as a single group;
  1. Investing in passively managed index funds does not equate to being a passive investor, as passive investment vehicles are oftentimes actively traded; and
  1. When comparing investment approaches, the degree of risk inherent in the approach must be considered. The greater the risk, the greater the expected return.

Generally speaking, active strategies have their best chance to outperform passive portfolios in downward trending markets, because most active strategies, including those developed and utilized by The Milwaukee Company, include a risk mitigation component not found in a passively managed portfolio.

Of course, not all active investment strategies are created equal.  While it’s not uncommon for stock picking strategies to do well over short time periods, they are much less likely to do so over the long term.  By comparison, there is a great deal of academic support for the notion that a sensible, sound, evidence-based investment strategy can produce superior risk adjusted returns over a complete business cycle.

That’s not to say active stock traders can’t outperform the stock market.  Clearly, there are stock jocks who have enjoyed long-term success.  If there weren’t, no rational person would engage in the practice.  However, that does not mean their success is due to skill.  Luck isn’t always a short-term phenomenon, and it is virtually impossible to differentiate between luck or skill, particularly over shorter-term periods.  By comparison, a rules-based investment strategy can be tested and re-tested to see how it would have performed in thousands of different market conditions.

To paraphrase novelist Lawrence Durrell: A successful lucky investment approach “is like a rare bird which cannot be seen.  What one sees is the trembling of the branch it has just left”.

Our advice; Don’t spend time searching for a bird you can’t see.

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Important Disclosures:  Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly from The Market Commentator℠, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio.  Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in The Market Commentator℠ serves as the receipt of, or as a substitute for, personalized investment advice from The Milwaukee Company™.