Timing and luck
Tuesday, October 16, 2012 at 10:00AM
Are successful people right, lucky or both?
In the mid-1980s, I listened to Nobel prize-winning finance professor, William Sharpe, address the Hong Kong Society of Securities Analysts.
Sharpe was one of our heroes, having developed the Capital Asset Pricing Model, or CAPM. We don’t need to go into that here, but for investment geeks at the time, CAPM was probably up there with sex.
Then the professor told us it was impossible to consistently beat the market.
Home truths and humility
Not everyone was happy with this. We admired the mathematics behind his models. It gave us the stamp-approval of science. But the idea that we couldn’t beat the market was less easy to digest. Our job was to come up with market-beating ideas. And after all, we were pretty smart.
Someone asked: how do you explain the track record of a particular fund manager (from memory, Peter Lynch, of Fidelity) who had been consistently beating the market?
Sharpe proposed a simple exercise. He reassured us we were all smart and that we would all toss a coin. Those with “tails”, roughly 50%, would leave the room. Then we’d do it again. And again, until one person was left. That person, said Sharpe, was Peter Lynch.
It’s been demonstrated many times since. It’s not simply the law of averages. You can get wrong-footed by a market but you can also get right-footed. It happens to smart people too.
A decade later, another Nobel laureate, Myron Scholes – who developed even sexier models than Sharpe – launched a fully hedged bond fund that couldn’t fail. When it did, it took a multi-billion dollar bail-out to avoid a viral financial disaster.
Both Lynch and Scholes were smart people. They were good at what they did. Markets went right for one; wrong for the other.
That’s what the chart below says. It’s from Dennison Hambling, Chief Investment Officer at First Samuel.
It’s very simple. It assumes that changes in the value of shares reflect changes in earnings per share (eps). That makes sense. If earnings go up, so will the share price. Add the dividend and you get the total return. This applies to all markets.
Using Australia as an example, eps has grown at an average of 8% per annum over the long term; the dividend yield has been about 4%. If that’s right, then total return should rise around 12% a year on average.
As the chart shows, that’s pretty much what happens.
The straight line equals 12%. The red line tracks total return. It can soar above the line or drop sharply below it. Invariably, though, it reverts to the 12% mean.
Next time you see a smart person going better than the rest, acknowledge their smarts and their hard work, but remember they may also have been right-footed. Too often we see only the downside as an aberration. In reality, the upside can be equally so.
Real value comes from sustaining earnings through both. If you can do that, it means when it comes to a business investment decision, you have the luxury of choosing your preferred aberration – whether it’s a time to sell a business, or alternatively, to invest in one.
decision-making, luck, management, strategy
Reader Comments (3)
The Long Term Credit Management (LTCM) fund that Scholes and others put together did not fail because the market went against them. It failed because the model didn't accomodate a so-called Black Swan -- in this case, the meltdown of the Russion bond market such that nothing could be priced. It was an exceptional circumstance that they had failed to accomodate in their modelling.
Amazing that some many people we thought were smart only a few years ago are not getting it right these days. Why does the media hype those people so much at the time. We'd have a lot better informed press if they didn't blindly accept that some successful people are not smart, they just get their timing right.
That's true Vanilla man, but the point is they got lucky with their timing.