Suspend your disbelief for a second. Imagine you have been gifted $1m, the only proviso is you must split the amount between an equally weighted 30-stock portfolio of US listed companies selected by Warren Buffett and a 30-stock portfolio of US listed companies selected by…me. You get to keep the amount staked on whichever portfolio produces the highest return.

Where would you put your money?

Of course, it is impossible to take any view on likely outcomes because we are missing a vital piece of information – the time horizon. When considering luck and skill in investing this is the most important thing. It changes everything.

Let’s say the time horizon was just a single day. The odds of my portfolio beating Buffett’s must be 50%. One day’s stock market movement is nothing but random noise. $500,000 each seems a prudent approach.

What if the length of the bet is increased to one year? The chances of my portfolio might be a little less than 50% but only modestly. Nobody can accurately and consistently predict in advance what will happen in equity markets over the next year. Fundamental company attributes are unlikely to matter that much compared to events, narratives and flows. The result would not be far from a coin toss.

How about three years? This is an important timespan because it is often the period over which fund investors hire and fire active managers. We should expect some advantage to arise from Buffett’s acumen and experience here, but the results would still be extremely variable and hugely influenced by sentiment, rather than the aspects of a business Buffett cares about.

We could use base rates to help us size the bet. Between 1988 and 2019 Berkshire Hathaway outperformed the market on c.60% of rolling 3-year periods.[i] A $600,000 stake towards Buffett would seem sensible.

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The tangential point here is that on the time horizon adopted by most fund selectors, Warren Buffett would have been sacked on multiple occasions over his staggeringly successful investing career. Past performance can be a terrible decision-making tool.

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Now, back to the bet. 

Finally, let’s try a 10-year time horizon. We are getting into the realms of long-term investing. Company fundamentals should matter more. Skill should start to exert a material influence. But how much?

Let’s go back to base rates. Over the same period as previously mentioned Berkshire Hathaway outperformed the market on close to 90% of rolling 10-year spells. We might now have more confidence placing $800,000 or $900,000 on Buffett’s side of the table.

Time horizons matter.

When thinking about the bet; don’t worry too much about my limited capabilities in stock picking, just assume that I design my 30-stock portfolio to look as much like the market as possible. Also, it doesn’t have to be Warren Buffett – just a highly skilled stock picking investor. The message will be the same.

So, what is the message?

1) Conversations about luck and skill in investing are irrelevant unless we specify a time horizon. For most styles of investing, the longer the time horizon the more skill will influence outcomes. Whatever the time horizon, however, the results will never be devoid of chance.

2) Investing is a bizarre activity. Over reasonably lengthy time horizons (one year, three years and more) people without any discernible skill will produce better results than the most skilful individuals in the field. There are very few activities that are structured in this way.

We hugely understate the role of luck in investment outcomes. Humility is a pre-requisite for good investing. Sensible decisions will appear mistaken – a lot.

3) Active fund investors have their time horizons all wrong. Attempting to identify skill and then worrying about one and three-year performance is entirely futile. We are doing little more than playing roulette (particularly if we acknowledge that we are unlikely to identify the greatest investor of their generation in advance). A focus on short run horizons will doom us to making persistently bad decisions based on the unpredictable movements of markets.

If there is any chance of success investing in active funds, we must extend our time horizon. If that is not possible, we should not be using them.
 

[i] Daily: Firing Warren Buffett | UBS Global