Never Lose Sight Of The Luck Factor In Portfolio Returns

by: Roger Nusbaum

Over the weekend I stumbled across a pretty good takedown of Modern Portfolio Theory, aka MPT. It is a good read but there was one nugget that I wanted to explore a little further;

The MPT Nitiot assumes skill has no bearing on outcome… perhaps the most fool-headed assumption academia has ever put forth!

The word 'nitiot' is a combo of nit and idiot.

Quite a few times over the years, mostly at Seeking Alpha, I've been called an MPTer which is not correct. I have been influenced by a few MPT concepts though. The question of how much of a role skill plays is an interesting one to explore. Layered on top of what role skill plays is the question of when it is skill and when it is luck.

Another source of influence has been Nassim Taleb and one positive I've taken from him is to never discount when you have been lucky with something (in this context lucky with something portfolio related).

The cognitive deficit of overestimating our own skill is something many of us observed or maybe even participated in by daytrading internet stocks in 1998 and 1999 and making a lot of money. Unfortunately very few people kept that money. Most of the people caught up in that craze were simply lucky enough to be in the right place at the right time.

However the idea that skill plays no role is not right either. One of the great spokesman for never trying to time markets or pick stocks has been Jack Bogle. Reasonably speaking he created indexing in fund form (he certainly brought more attention to it than anyone else), he gets a lot of face time and delivers the same advice about how to diversify with broad index funds and I believe he is sincere. However based on my casual observation, he is better than most at doing what he says can't be done; calling major turns in the stock market. If an interviewer presses him he will give an opinion and he has been right quite a few times.

It is not terribly shocking he has been correct about this before; he has been around markets since the 1950s so he has seen a lot. Bogle clearly loves his involvement with markets, and obviously he is brilliant. He might be wrong in the future of course, but he would seem to be more likely to understand markets better than most.

The approach I write about and use to do my job hopefully is cognizant of the luck factor and so not 100% reliant on skill. More correctly, clients are not subjected solely to whether or not I am right about something. In many posts I have talked about trying to catch tailwinds for the portfolio. For example looking to add industrial sector exposure early in the stock market cycle offers the potential for a tailwind. Or adding energy or materials exposure early in the economic cycle as demand for these resources is likely to increase, creating tailwind for the stocks.

These are bigger and broader things than the bottom up endeavor of picking between two companies offering similar but competing products.

This is not to say that there are no narrow bottom up decisions made because there are, just not exclusively. A big feature with top down investing, as I see it, is finding tailwinds, which is easier than bottom up stock picking, because even if you don't pick the best stock your portfolio will likely still benefit from the exposure.

By the same token this allows for locating headwinds and avoiding the worst areas. Certainly there are Japanese stocks that have done well but in a market that has been down 35% in the last five years, the path of least resistance has simply been to avoid that market. The odds of finding a stock that goes up in a down 35% world are low and the task very difficult.

There can be skill involved in portfolio management but there is also plenty of luck and hopefully we never lose sight of that.