Why Past Fund Performance Doesn’t Guarantee Skill

Imagine you’re trying to figure out if a basketball player is truly skilled or just on a lucky streak. You watch them play a few games, and they make some amazing shots. Does this mean they are a guaranteed superstar, or could they just be having a good run of luck? This is very similar to the challenge we face when trying to evaluate fund managers based on their past performance.

Fund managers are essentially professionals who invest money on behalf of others, aiming to grow those investments over time. They make decisions about which stocks, bonds, or other assets to buy and sell. Naturally, when we are looking for someone to manage our money, we want to choose someone who is skilled, someone who can consistently make good investment decisions. Past performance, how well a fund manager has done in the past, seems like a logical place to start our evaluation. If a fund manager has consistently delivered high returns, it’s tempting to think they must be truly talented.

However, the world of investing, much like many aspects of life, is influenced by both skill and luck. Think of it like flipping a coin. If you flip a coin ten times and get heads eight times, you might start to think you have a special coin or some kind of coin-flipping talent. But statistically, it’s quite possible to get eight heads out of ten flips just by pure chance. Similarly, in the stock market, sometimes good things just happen. A particular sector might do exceptionally well due to unforeseen events, or a general market upturn could lift all boats, including those managed by less skilled individuals.

The challenge is separating the signal of genuine skill from the noise of market randomness. Imagine a hundred monkeys throwing darts at a stock market dartboard. Statistically, some of those monkeys, purely by chance, will pick stocks that perform exceptionally well over a certain period. If we only look at the top-performing monkeys after a few years, we might mistakenly conclude they have some special stock-picking ability. This is a simplified, but illustrative, example of how luck can masquerade as skill in the financial world.

Furthermore, financial markets are incredibly complex and influenced by a vast number of factors. Interest rates, global events, technological advancements, and even investor sentiment can all play a role in how investments perform. Attributing past success solely to a fund manager’s skill often overlooks the influence of these broader market forces. A manager might have made some smart decisions, but their positive performance could also be significantly boosted by a favorable economic environment or a lucky bet on a booming sector.

Another important factor to consider is survivorship bias. When we look at past performance, we are typically only looking at funds that are still around. Funds that performed poorly often get closed down or merged with others, effectively disappearing from the historical record. This means that the pool of past performers we observe is already a biased sample, skewed towards those who have been relatively successful, even if some of that success was due to luck. It’s like looking at a group of lottery winners and concluding that buying lottery tickets is a guaranteed path to wealth, ignoring all the people who bought tickets and didn’t win.

While past performance isn’t entirely meaningless, it’s crucial to understand its limitations when assessing fund manager skill. It’s more like a blurry photograph than a crystal-clear image of talent. Genuine skill in fund management certainly exists, and skilled managers likely make better decisions on average over the long run. However, in the short to medium term, and sometimes even over longer periods, it can be incredibly difficult to definitively isolate and measure that skill from the inherent randomness and unpredictable nature of financial markets. Therefore, while past performance can be a starting point, a more comprehensive evaluation requires looking beyond simple returns and considering factors like investment strategy, risk management, and consistency of performance over various market cycles to get a more nuanced, though still not conclusive, picture of a fund manager’s true abilities.