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).