Talent & Luck

Regression to the mean was discovered and named late in the nineteenth century by Sir Francis Galton, a half cousin of Charles Darwin.  In statistics (and in investment management), regression to the mean is the phenomenon that extreme measurements, tend to be followed by measurements that are closer to the average.

In sports, regression to the mean may be the reason for the “Sports Illustrated Cover Jinx” and the “Madden Curse”.  It is also likely to explain why the best performing golfer on the first day of a tournament is likely to be less successful on the second day and why firms with the worst ratings in Fortune’s Most Admired Companies go on to earn much higher stock returns than the most admired firms (which coincidentally does not bode well for the current hedge fund love-affair with Apple, but does offer promise for our current investments in Dell, Hewlett Packard and Xerox).

In Thinking, Fast And Slow, Daniel Kahneman, winner of the 2002 Nobel Prize in Economics, explains that regression effects are ubiquitous, as are the misguided stories to explain them.  Kahneman warns that, “Our mind is strongly biased toward causal explanations and does not deal well with ‘mere statistics.’  Causal explanations will be evoked when regression is detected, but they will be wrong because the truth is that regression to the mean has an explanation but does not have a cause.”  In other words, as much as we’d like to believe the stories which “explain” the phenomenon, our stories are likely just narrative fallacies – flawed stories of the past that shape our views of the world and expectations of the future.  “Narrative fallacies arise inevitably from our continuous attempt to make sense of the world.  The explanatory stories that people find compelling are simple; are concrete rather than abstract; assign a larger role to talent, stupidity, and intentions than to luck; and focus on a few striking events that happened rather than on the countless events that failed to happen.”

The human mind does not deal well with nonevents.  “The fact that many of the important events that did occur involve choices further tempts you to exaggerate the role of skill and underestimate the part that luck played in the outcome.”  Another limitation of the human mind is our imperfect ability to reconstruct past states of knowledge and the tendency to revise history in light of what actually has happened.  This hindsight bias leads us to judge the quality of a decision not by whether the process was sound but by the outcome, making it almost impossible to evaluate decisions properly.  We would tend to agree with Kahneman (although certainly biased) that, “Hindsight is especially unkind to decision makers who act as agents for others . . . We are prone to blame decision makers for good decisions that worked out badly and to give them too little credit for successful moves that appear obvious only after the fact.”

Howard Marks recently published an excellent note on Assessing Performance Records in which he discusses this outcome bias and the dilemmas faced by anyone tasked with structuring a portfolio.  The full letter is worth a read.  In it, Marks explains that, “In order to survive and have a chance to produce long-term performance, investors have to live up to their constituents’ expectations in the short run.”  Sounds easy enough, except when one considers that timing is incredibly imprecise and incredibly significant in terms of outcomes.  Expensive stocks can get more expensive (as we’ve experienced many times before) and cheap stocks can get cheaper (once again, consistent with our investments in Dell, Hewlett Packard and Xerox), thus timing plays an important role in the perception of success or failure.  Marks’ reminds us of the old adage about the six-foot-tall man who drowned crossing a stream that was five feet deep on average.  “In investing, it’s not enough to survive on average. You have to survive on the worst days, when the low points in the market are reached.”

For our part, we continue to see a severe disconnect between financial markets (which have rallied sharply) and underlying economic conditions (which we expect to weaken materially), putting stocks at risk of disappointment in the near term.  But while we remain concerned about the next few years as we work off the excesses of the past few decades, we are very bullish on the stocks we own for the long term.  We just need to make sure we survive on “the worst days” to get there.  So between now and then, we will continue to focus on process over outcome, we will look to capitalize on mean reversion rather than the blind extrapolation of trends, and we will tread carefully around any supposedly harmless streams.