Luck, Skill, Glory, Grief

The headlines elicit fear of a European rendition of the Financial Crisis of 2008, and with that foreboding backdrop, other headlines hype the President’s upcoming speech on the economy. Markets continue to whipsaw throughout the day, leaving us at week’s end feeling like we need to catch our breath. Leading experts hold forth theories of behavioral finance for why the markets seem so topsy-turvy, while others offer recommendations we all know are destined for the dust bin of political partisanship on how to get millions upon millions of unemployed people working again.

None of these narratives seem to acknowledge the fundamental forces shaping our lives and our livelihoods – forces that have been acknowledged through time by society’s most articulate thinkers. In their new translation of Aristotle’s Nichomachean Ethics (University of Chicago Press, 2011), Robert C. Bartlett and Susan D. Collins remind us that the connection between luck and one’s position in life was first observed over twenty-five centuries ago, in Homer’s Iliad:

“Priam, the highly respected king of Troy … witnesses the destruction of his city in the course of the Trojan War and so loses all that his great virtue and fortune had bestowed on him, not least his fifty sons” (p. 18, footnote 61)

Putting aside for the moment the vague and complex concept of “virtue,” Priam’s position in society as a wealthy king is attributed, in what is considered to be the inaugural Western epic, to luck. Bartlett and Collins refer to Homer as they translate Aristotle’s discourse on the roots of happiness. Consider this excerpt of the final passage in Book 1, Chapter 10 of Aristotle’s Ethics:

“Now, many things occur by chance, and they differ in how great or small they are. The small instances of good fortune, and similarly of its opposite, clearly do not tip the balance of one’s life, whereas the great and numerous ones that occur will make life more blessed … But those fortunes that turn out in the contrary way restrict and even ruin one’s blessedness, for they both inflict pains and impede many activities.” (p. 20)

What fascinates me is how the premise that a combination of luck and skill materially influences our lives has over the millennia transformed into a presumption of skill (or lack thereof). The most salient example of this transformation is the modern investment business, in which professionals research, analyze and report on fund performance as if most (if not all) of that performance is attributable to skill. As we saw recently in the collapse of Bernie Madoff’s Ponzi scheme and Raj Rajaratnam’s conviction on insider trading on behalf of his hedge fund, Galleon, examples of how we are prone to mistake chicanery for skill crop up every few years. Our being fooled by those convicts is arguably but an extension (admittedly, an extension taken to its logical extreme) of our tendency as humans to be misled by the routine pronouncements of historical performance as declarations of superior skill on behalf of investment professionals.

What makes me so confident in suggesting that we may be systematically mistaking luck for skill? Consider the conclusion drawn in a recent study published by Eugene F. Fama (of the Booth School of Business, University of Chicago) and Kenneth R. French (of the Amos Tuck School of Business, Dartmouth College), entitled “Luck versus Skill in the Cross-Section of Mutual Fund Returns”:

“The aggregate portfolio of actively managed U.S. equity mutual funds is close to the market portfolio, but the high costs of active management show up intact as lower returns to investors … [S]imulations suggest that few funds produce benchmark-adjusted expected returns sufficient to cover their costs.”
(The Journal of Finance, Volume LXV, No. 5, October 2010, p.1915)

In other words, the professionals in our nation’s mutual fund industry may not, with few exceptions, be able to justify their management fees with commensurately higher returns to investors. Yet we continue to trust our nest eggs with them. While we sometimes spend substantial portions of our limited free time at big box stores devising the means to upgrade the kitchens, bathrooms and furniture of our homes, firm in the belief that it is best we do the heavy lifting ourselves, we fully entrust this group of professionals with our financial futures. All the while, the expenses charged often exceed the value provided.

What can one do to acknowledge and put to use the Fama and French study’s conclusion? By spending more of that limited free time building and maintaining a portfolio of no-load, low-cost index funds. In doing so, we earn a return that includes what we would otherwise have paid the active fund managers (or, as Vanguard founder John C. Bogle might put it, “less for the active managers means more for us”), reduce the risk of those returns via the diversification that comes with the use of those broad market index funds, and enjoy the “miracle of compounding” by buying and holding those funds for the long term.

Several centuries after Aristotle, Virgil best summarized the mixture of action and chance that so often seems to shape our lives, and I submit to you, our financial destiny:

“How each man weaves
his web will bring him to glory or to grief…
The Fates will find the way.”

(Aeneid, Book 10, translation by Robert Fagles, Penguin Classics, 2006, p.297)

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