Luck vs. Skill

The media loves a good story. Can you blame them? So when a stock picker finds random success, the media adorns them with guru status. When their fleeting success fades, the guru title is handed to the next lucky stock picker. Unfortunately, luck is not a repeatable skill. Mark Hulbert clearly articulates this fact in his 2008 New York Times article, “The Prescient are Few.”1 The article details the findings of a study2 by professors Laurent Barras, Olivier Scaillet and Russell Wermers about the performance of 2,076 mutual fund managers over the 32-years from 1975 to 2006. The study found that 99.4% of the managers displayed no evidence of genuine stock picking skill, and that the 0.6% of managers who did outperform the index were “statistically indistinguishable from zero,” or as Hulbert puts it, “just lucky.” Figure 3-1 depicts the study’s results.

Figure 3-1


A statistical test called the Student’s t-test was introduced in 1908 by William Sealy Gosset, referred to as the “Student,” while working for the Guinness brewery in Dublin, Ireland to evaluate the quality of the brewery’s ingredients. The t-test can be used to determine if a series of historical returns is reliably superior – showing a t-statistic of 2 or higher – to a risk-equivalent benchmark. This can determine whether alpha (returns relative to its benchmark return) is due to luck or skill. In Figure 3-2, the t-test is applied to U.S. equity funds in six different style classifications over a 20-year period. Out of 438 mutual funds constructed with at least 90% U.S. equities, 98.4% of those fund managers did not have a statistically significant alpha, meaning any alpha they did have was due to luck, not skill. See the Step 5 Solutions section for a further explanation of the t-statistic.

Figure 3-2

    -1 Mark Hulbert, "The Prescient are Few," New York Times (New York, NY), Jul. 13, 2008.
    -2 Laurent Barras, Olivier Scaillet and Russ Wermers, "False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas," The Journal of Finance, vol. 65, no. 1 (2010).
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