We are human, and therefore prone to seeking natural patterns, according to Michael Mauboussin. He’s the author of "More Than You Know: Finding Financial Wisdom in Unconventional Places," and a man intrigued with probabilities.
Starting with patterns, the author referred us to the belief that basketball players can have “hot hands.” Theoretically, if a player makes a few baskets in a row, then they have a higher-than-average probability of scoring on the next shot.
Not true, argued Mauboussin, pointing out the scientists studied statistics for two NBA teams and found no evidence of the hot hand. While players did score on successive shots, those streaks were “completely consistent with probabilities.”
He went on to observe:
“The main point here, though, is not that humans are poor at relating probabilities to sequences of outcomes. The more important issue is that streaks inform us about probabilities. In human endeavors, unlike a fair coin toss, the probabilities of success or failure are not the same for each individual. Long success streaks happen to the most skillful in a field precisely because their general chance of success is higher than average.”
In other words, you can improve your chances of enjoying a winning streak by honing your skills. Or, as Mauboussin would put it, increasing the probabilities of success.
To illustrate, he told us of two imaginary basketball players, Sally Swish and Allen Airball. Sally, being more skilled, makes 60% of her shot attempts, while Allen converts only 30% of his shots. What, then, is the probability each will make five shots in a row?
- For Sally, the odds are 7.8%
- For Allen, the odds are only 0.24%.
Given these odds, Sally is likely to score five shots in a row roughly every 13 sequences. For Allen, five in a row is likely to happen once in every 412 sequences. While staying within probability principles, Sally will enjoy a lot more streaks than Allen.
What about coin tosses? Mauboussin told us that finance teachers use the coin-tossing metaphor to show market efficiency. For example, in a field of 1,000 funds, and assuming a 50-50 chance of beating the market, about 30 funds will beat the market five years in a row.
But, of course, some managers are more skilled than other managers. Consider again the case of Bill Miller of the Legg Mason Capital Management Value Trust Fund, who beat the S&P 500 for 15 consecutive years, 1990 through 2005. It was the only fund in 40 years to achieve such a heady result.
As the author pointed out, many pundits said Miller’s record was simply a matter of chance (i.e., it could be explained with probabilities). Among the critics was Bill Gross, himself a star bond fund manager; after 12 years of Miller’s run, Gross said it was simply the equivalent of rolling twelve sevens in a row using a pair of dice. Mauboussin wrote:
“Gross 'snarled' that Miller’s performance is equivalent to rolling twelve sevens in a row with a pair of dice. We can only hope that Gross, who has a great investment track record and familiarity with gambling, was misquoted: The odds of rolling twelve sevens in a row are approximately 1 in 2.2 billion.”
If we assume that a constant 50% of funds beat the market each year and assume market performance is the equivalent of a coin toss, then the probability of one specific fund outperforming the S&P 500 for 15 consecutive years is one in 32,768. In reality, the odds of all funds outperforming were just 44%, which meant the probability dropped to 1 in 223,000.
A more demanding analysis looks at the actual percentage of funds that beat the S&P 500 each year for a cumulative probability. During the period Miller outperformed, there were two years in which only about 10% of funds beat the benchmark; this more realistic analysis puts the odds of what Miller did at roughly one in 2.3 million.
Building on that, Mauboussin noted that streaks are intriguing money management phenomena because they do not allow for any bad years. What’s more, the longer the streak, the greater the pressure and the greater the tension on the manager.
The author wound up the chapter by putting Miller’s achievement into context:
“Was Miller lucky along the way? Without a doubt. But as Stephen Jay Gould says, long streaks are extraordinary luck imposed on great skill. The central message is that across domains, long streaks typically indicate skill. And since humans have a hard time relating to all but the easiest probabilities, we often fail to see the significance of streaks.”
Conclusion
I titled this digest of chapter seven “What’s Behind Investing Hot Streaks?” Mauboussin answered that question by explaining that both luck and skill have a role in hot streaks. More importantly, skill is something within our control and within our capacity to increase. Your probability of turning in multiple years of beating a benchmark goes up as your skill increases.
To add to that, I’d like to bring your attention to compounding. The more years of success, or the greater the magnitude of your successes, the greater the effect on compounding your capital. Obviously, it would be nice to have streaks, but even avoiding losses is productive. As long as you can stay in the black, the better your odds of enjoying a comfortable retirement or other important goals.
Read more here:
- More Than You Know: Experts and the Issues They Confront”‹
- More Than You Know: Risk, Uncertainty and Prediction
- More Than You Know: What About Circumstances?
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
