Investing sits toward the luck side of the continuum not because investors are not skillful but because, in effect, their skills offset one another through efficient prices. The classic random-walk argument goes roughly as follows: All relevant information about stocks is reflected in the price today, therefore only new information should change stock prices, and new information, by definition, is random. That's not perfectly accurate in the real world, but as a rough sketch of what's going on, it's not a bad place to start. There has to be some active management in order to ensure that information is reflected in prices.
The second thing is, I think the evidence shows that while there's a lot of randomness in investing, there is indeed differential skill. And there are ways to think about trying to identify a priori that differential skill. For people who are not interested in getting into that, indexing makes a lot of sense; for those that are motivated, there may be some paths to trying to do that intelligently.
Can a portfolio manager move close enough to the skill side that shareholders can be confident there's at least as much skill as luck at play?
It's a super-interesting question. I think that someone like Buffett you could say quite confidently is very skillful. I think he's enjoyed a bit of good luck along the way, but that's fine. This gets to an essential question, which is, "How might you come to that conclusion?" There are two fundamental approaches to this. This first is to look at outcomes. With someone like Buffett, the track record tells you all you need to know. But for most portfolio managers, their track records are simply too short.
So the second approach, which I advocate for, is to focus on their process. That, to me, is the key to illuminating skill. For instance, I might give you $1,000 to see if you know how to play blackjack. You go off and play for the evening, then return and give me whatever you have made. We know the results are going to be largely influenced by luck. The alternative is to give you $1,000, then look over your shoulder and watch your decision-making to see if you're playing basic strategy. If you are, I know that you're going to do as well as you can over time because your process is a good process.
Do you suggest a minimum tenure needed to discern skill from luck?
I've always tended to balk at this kind of approach because it assumes a purely random process. I wouldn't give a number on that. There can be investors who have a poor process but a pretty good track record, and I wouldn't want to incrementally give them any of my dollars. And there can be people with relatively short track records who do seem to have a good process, and I'd be more comfortable giving them money.
If you think fees are too high, would performance fees be the answer? Could the fund industry run on that basis?
I think it's less true for retail, but in the institutional money-management world, there is already a fair bit of that—performance fees. What you really want to reward are people who are operating with a proper and thoughtful process every single day. Over the long haul the best processes win, but in the short term they may not. Whenever compensation gets too linked to luck, good or bad, it makes me a little bit leery.