Last night I had the privilege to participate in a panel discussion, organized by Rutgers University Professor Jim Bicksler, at the Dow Jones facility in Princeton, NJ, titled "Investment Principles Revisited." You're no doubt not surprised that the principle I dealt with had to do with how returns are calculated.
During the Q&A session an attendee referenced John Paulson, the hedge fund manager you may recall who made billions of dollars on shorting credit default swaps. I saw his success as being a “black swan,” in the words of author Nassim Taleb, but one at the positive end of the curve. And while Taleb tended to focus more on the black swan events on the negative end, we can identify many that are at the positive. At the time Paulson made his bet, would many have said that it was a shrewd one, guaranteed to generate tremendous returns? Clearly this is a purely academic question for which no answer is known. But we do know that there were many others, such as AIG, who (incorrectly, as it turned out) were long CDSs.
Can we attribute skill or luck to the extreme success that was received by this bet? Again, we simply do not know. What we do know is that those who have big successes often have big failures, too. For several decades Baseball Hall of Famer Babe Ruth held (without the help of any performance-enhancing drugs) the records for most home runs in a year and career. But he also was the holder of the record for most strikeouts in a year and career for a long time. Was his strategy to swing hard and hope that the bat made contact with the ball in such a manner as to cause the ball to leave the park? I don’t know, but what we do know is that he had “outliers” at both the long and short ends of the curve. Today, Ryan Howard of the Philadelphia Phillies is paid US$15 million a year because of his prowess at hitting the baseball a long way. But he, too, has held the record for the most strikeouts in a year as well as the most home runs.
We only know if a strategy is a good one after the fact. In the 18th century I bet most people would have guessed that Antonio Salieri had a better chance of long-term success than Wolfgang Amadeus Mozart. And yet, had it not been for the 1984 movie, Amadeus, it is likely that very few today would know who Salieri was.
The wealthiest man in the world, Bill Gates, is applauded for his business acumen and keen insights into the world of software. And yet, many don’t recall that early on he offered to sell IBM his DOS operating system for the lofty sum of $85,000, a deal for which IBM was criticized for passing up. But what does this offer say about the man, Bill Gates? His interest at the time was to develop compilers (software that converts programming languages into the code that makes them run). Had IBM taken Mr. Gates up on his offer, it is highly likely that we wouldn’t know who he was today.
In his best seller, Outliers, Malcom Gladwell discusses the reasons for much of the success we find today. In reality, it’s not always (or often, for that matter) purely skill, but much of the time has a degree of luck attached to it. Individuals who make big bets, who try to hit the ball out of the park, are often met with failure. John Meriwether, of Long Term Capital Management fame, is in the process of shutting down his second hedge fund. For a number of years he was hitting the balls out, but in the long term, his success appears somewhat mixed.
There is clearly a degree of risk associated with any long ball hitter. When the individual goes to the plate, we have no way of knowing what the outcome will be. The same holds true with investors, especially those who make extreme bets. Even though their decisions may be made on sound and thorough analysis, we won’t know if they were right or wrong until afterwards. Only at that time can we look back and applaud them.
I used as an analogy this year’s Kentucky Derby Winner. At the time the race began, very few believed that Mine That Bird would be the winner...had they, the odds would have been quite different. And that day, a few believers won a lot of money by betting correctly on the outcome. But betting on longshots is, in most cases, a poor investment strategy. Granted, you only need one Mine That Bird to make your long-term performance a good one. But at the time anyone making such a bet was no doubt thought of as being somewhat foolish. A sports radio personality, who is highly regarded for his horse racing knowledge, didn’t make such a prediction. Likewise, in this year’s U.S. Open no one would have guessed who the final four golfers would be. In fact, only one of the final four (Phil Mickelson) had been identified as a potential winner. I was at the Open for the third round and picked up a program that didn’t even bother to mention Lucas Glover (the winner); nor did it mention David Duval or Ricky Barnes (the gentlemen who were tied with Phil for second place).
All of this has to do with predictions. No one knows what’s going to work, who’s going to win, or what the outcome will be. Outliers at the positive end deserve their recognition and applause, no doubt, but surely there must be some degree of luck involved to go along with their skill