Hang Seng Index

Investment success can really be down to the flip of a coin

PUBLISHED : Friday, 05 May, 2006, 12:00am
UPDATED : Friday, 05 May, 2006, 12:00am


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If you are wondering whose investment advice to listen to, here is a small piece of advice about advisers: it pays to be deeply suspicious of investment 'gurus'.

To understand why, conduct a simple thought experiment. Imagine that 10 years ago 1,000 money managers set themselves up in business. On New Year's Day 1996 each manager tossed a coin to determine what he or she thought the Hang Seng Index would do over the next 12 months.

The ones that threw heads decided the market would rise, and invested their clients' money in long positions. Those that came up tails thought markets would fall, and went short.

At the end of the year, the half that was right would have made a pot of money. The other half would have got it desperately wrong.

Now, imagine that all the managers who lost money went out of business at the end of the first year, and that the remaining 500 again flipped coins to determine their investment positions for the following year, 1997. Once again, half would be on the right side of the market, and half would lose a packet and end up working in Wan Chai as barmaids or waiters.

At the end of the second year, our original 1,000 would have been whittled down to just 250. At the end of 1998, there would be 125, and so on.

Guess what. By the start of this year, there would have been just one survivor left (well, statistically speaking, 0.98, but let's not split hairs). Only one manager out of the original 1,000 would have called the markets correctly every single year for 10 years.

Just think how much money he would have made. The successful adviser would have ridden the Hang Seng Index's bull market on the way up through 1996, only to have gone short for the market crash of 1997.

He would have bought stock ahead of the technology boom of 1999, but been positioned short for the long three-year bear market that followed. Then, in 2003, he would have bought back in again in time to catch the Hang Seng Index as it rebounded from the Sars crisis.

His returns would have been phenomenal. At a conservative estimate, he would have earned his investors 766 per cent over 10 years (less fees). In contrast, a manager who simply bought and held the index would have made just 48 per cent.

Without doubt, our sole survivor would be hailed as a guru of investment strategy. His every tip would be breathlessly reported in the financial pages and on the business television channels.

And it would all have been achieved by pure blind chance. At the end of this year, there would still be a 50-50 chance our guru will lose everything.

That is merely a thought experiment but all this actually happens in real life. Think back, and you will remember Julian Robertson, legendary boss of the Tiger Fund. After making stellar returns investing in US stocks through the 1980s and 1990s, he managed to get on the wrong side of the tech boom in 1999. His fund was wound up in early 2000 after seeing its assets under management fall by US$16 billion in little over a year.

Then there was Long Term Capital Management, run by not one but three gurus, including two Nobel economics laureates. That outfit went bust in 1998, prompting the US Federal Reserve to mount a rescue to save the US financial system from collapse.

Even George Soros has come a cropper. After correctly calling the 1987 stock market crash, busting the British pound out of the European exchange rate mechanism in 1992 and breaking the Bank of Thailand in 1997, he then lost billions in a matter of days when the Nasdaq bubble burst in March 2000.

The sad truth is that that old disclaimer 'past performance is no guide to future returns' is absolutely true, as numerous studies have proved. So beware of gurus. Their historical success could well be just sheer luck and it could run out at any minute.