Buyer beware: The 2020 performance scoreboards that will soon dominate the financial media are next to worthless as a basis for picking an adviser.
That’s because short-term performance — including calendar-year returns — are almost completely statistical noise. A strategy of following last year’s top performer is a recipe for losing a lot of money.
Consider a hypothetical portfolio that, each Jan. 1, began following the advice of the investment newsletter at the top of the Hulbert Financial Digest’s performance scoreboard for the prior calendar year. Over the past three decades this portfolio was almost a complete wipeout — producing an annualized return of minus 16.7%.
Don’t conclude from this result that you should instead follow the opposite strategy of following the previous year’s worst performer. That strategy lost even more over the past three decades, believe it or not. The proper conclusion is that the one-year returns are essentially coin flips.
How long a track record do you need before you can be even somewhat confident that you’re basing your choice of adviser on more than just luck? The answer will surprise you: It is a lot longer than you think.
A whole lot longer.
Consider a simple coin-flipping experiment conducted a couple of years ago by James White, founder and CEO of Elm Partners, along with two colleagues: Imagine that you have three coins, two of which are “fair” coins while the third comes up heads 60% of the time — but you don’t know which is which. How many flips of these coins do you need before you can be 95% confident that you can identify the unfair one?
The answer, believe it or not, is 220.
To be sure, an adviser’s performance over a calendar year is not precisely equivalent to one coin flip. But the researchers argue that it’s closer than you might think. For example, Warren Buffett, CEO of Berkshire Hathaway BRK.A BRK.B and widely considered to be the most successful manager alive today, has beaten the S&P 500 in precisely 60% of the past 25 calendar years.
Most other advisers, in contrast, are the functional the equivalent of the “fair” coins that come up heads just 50% of the time.
Furthermore, the researchers argue, their coin-clipping analogy may even be too generous. That’s because advisers’ yearly returns tend to regress to the mean.
An Illustration: GMO’s 7-Year Forecasts
To illustrate the investment implications, I want to focus on the bearish forecasts made over the past decade by Jeremy Grantham, co-founder of Boston-based GMO. In the early years of this century, Grantham made a name for himself by correctly anticipating both the Internet and housing bubbles in 2000 and 2007. And, far from being a bearish stopped clock, he issued a remarkably well-timed buy signal on stocks near the bottom of the bear market in 2009.
More recently, however, Grantham has become almost as well known for being extremely bearish on U.S. stocks. In December 2013, for example, GMO was forecasting that the S&P 500 between then and today (in December 2020) would lag inflation at an annualized rate of 1.3%.
In fact, of course, the S&P 500 did far better than that: It beat the Consumer Price Index by 11.1 annualized percentage points over the past seven years. That’s nearly double the stock market’s long-run average real (inflation-adjusted) return.
What can we conclude from an adviser who makes three spectacular calls and one terrible one? On the one hand, the coin-flipping analogy reminds us that it would be premature to dismiss Grantham and GMO. Difficult as it is for us to accept, lagging the market by so much in recent years could have been mere bad luck.
My goal in pointing this out is not to defend Grantham and GMO. I am focusing on them because, despite being so spectacularly and prominently wrong in recent years, we can’t automatically conclude that we should stop following them.
Note carefully, however, that this judgment does not amount to a “get out of jail free” card for Grantham and GMO. Based on the Elm Partner’s analysis, it’s also possible that their impressive calls at the top of the Internet and housing bubbles, and at the bottom of the 2009 bear market, were themselves due to nothing more than luck.
In other words, we just don’t know. It’s possible that the adviser at the top of the performance scoreboards is truly skilled; but it’s also possible that he or she was just lucky. By the same token, the adviser at the bottom of the rankings might be truly awful, or just unlucky.
That doesn’t mean we give up. But it does mean we should operate with a healthy dose of humility about what we know and don’t know.
For most of us, this means we heavily favoring index funds in our portfolios.