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The lessons of Woodford

21st October, 2019

Sporting stories of triumph followed by disappointment are legion. Think Claudio Ranieri’s Leicester football club, the Oakland A’s baseball team or golfer David Duval. The tragic career arc of success that turns out to be fleeting afflicts many domains from sport to business and the arts. Somewhat less obviously it influences the investment world also. 

For the past six months there’s been a developing story in the UK relating to the implosion of the career of celebrated stock picker, Neil Woodford. Much ink has been spilled in the diagnosis of what happened, which I won’t cover here. Suffice to say, the much-feted fund manager, widely regarded as the UK’s best stock picker, enjoyed a considerable period of success before recent troubles which came to a head this week as he was sacked as manager of his flagship equity fund.

 

What happened to Woodford?

Financial Times columnist Tim Harford posits three broad explanations for Mr. Woodford’s travails, an exploration of which I think is required reading for any would-be investor. 

It’s possible that Mr Woodford lost his touch. Successful people can become overconfident or complacent. There may be some merit to this, but it strikes me as a little insufficient as an explanation. 

A more likely possibility is that the world changed. Billy Beane’s success with the Oakland A’s baseball team (as depicted in the movie Moneyball) was once unusual, but when the competition noticed, the edge disappeared. In investing, having an edge is all important, but capital markets are complex and adaptive, so the advantage from good ideas tends to decay once rivals figure it out. 

A third possibility, and the one we are most likely to resist as an explanation is: that luck was involved. To be fair, this looks like a stretch.  Afterall, Mr Woodford had a track record of above average performance that was anything but fleeting – at least not in the same category as Leicester. Nevertheless, we must consider the possibility. As the poet Jean Cocteau wittily observed, “We must believe in luck. For how else can we explain the success of those we don't like?”.  
 

Was luck really part of the saga? 

Despite our best efforts, the idea that things might not work out the way we want because of randomness is very unedifying. It’s more than a little uncomfortable to think that people we entrust our savings to, might in some way be essentially flipping coins. But consider the possibility we must. 

Acceptance of the role of luck in outcomes is a necessary prelude to good decision making. It’s about making better decisions, when we don’t have all the facts. And rarely in investment markets will you be operating under these conditions. When we accept that we can’t be sure, we are less likely to fall into the trap of black-and-white thinking; That actions have some predictable outcome. 

All of this is not to say that skill doesn’t matter — clearly it does. But in highly skilled and competitive environments, luck will play a greater role in the outcome, than where skill levels vary widely. Good luck plus skill beats bad luck plus skill all day. This has been coined the ‘paradox of skill' - where luck explains the difference between triumph and failure. 

The relevance of this to investing today is particularly pertinent, given the inexorable rise of passive investing. At first blush, the rise of passive looks like a trend that should be a boon to stock pickers like Mr Woodford; afterall, the more ‘dumb’ money that invests based upon a ‘paint by numbers’ passive approach, the greater the inefficiencies for active managers to exploit. Not if the lunch that passive has been eating is mostly that of the unskilled active managers. 

It’s hard to know whether passive has been sucking the ‘dumb-money’ from the active game. But one way of assessing this is to observe whether the variance in performance between the best and worst fund managers has been narrowing. According to the well-known investment author Michael Mauboussin the variance in fund returns has been declining for the last 50 years. When you have more skill, results become more uniform and so luck has more room to influence outcomes.
 

The lessons from Woodford

The Woodford tale follows a pattern we all notice - genius followed by mediocrity. As Tim Harford notes, mediocrity followed by genius just looks like genius. So, it’s nigh on impossible for us to tell where the next banana skin lies.

The dust has not yet finally settled on the Woodford affair. Perhaps Neil Woodford was unlucky. Perhaps he became complacent. Or maybe the world adapted, and he didn’t. 

Whether it’s soccer, baseball, golf, or investing, we would do well to make peace with the idea that we can’t know for sure what contribution luck, graft, or adaptability have in the outcome. And that’s okay. But if you can’t accept this, surprises will always lie in wait.

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