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Breaking the Track Record Addiction to Build a Practice that is “Beyond Reproach”

by David B. Loeper, CIMA®. CIMC®

Aristotle is often credited as the originator of the law of causality. Essentially, he was distinguishing the difference between being able to prove the cause of an observation versus merely observing an outcome from different perspectives. One example of why understanding this difference impacts ethics and integrity (or the lack thereof) in our industry can be seen in the tendency of advisors to falsely identify the cause of investment results. Many advisors automatically assign “skill” to above average track records and completely ignore the portion of the observations that would have definitely occurred randomly in the complete absence of skill.

To think about this objectively, let’s examine the distribution of random outcomes of six flips of a fair (balanced) coin. In the case of coin flips, we know that there is no skill involved and the outcomes are merely the result of mathematical laws that must be true. There are 64 unique potential outcomes for six coin flips.  In Table 1 we show the number of observations and the probability distribution of the counts of flipping heads in six coin flips.

Now presume for a moment that flipping heads equated to one year of outperformance on a risk adjusted basis. Morningstar assigns five stars to the top 10% risk adjusted returns in a peer group. This approximates the probability of flipping five or more heads out of six flips (an 11% chance, 1.6% plus 9.4%).  Morningstar assigns four star ratings to the next 22.5% which we can think of as outperforming on a risk adjusted basis in four of the last six years, which approximates the 23.4% chance of flipping heads four out of six flips. Only 32.5% of a universe earns four or more stars, yet if it were just random coin flips 34.4% would flip four or more heads.

I do not find it the least bit ironic that the four-star rated Growth Fund of America outperformed four of the last six years relative both to the S&P500 and the category average. If a million monkeys randomly picked stocks from the newspaper, 23.4% would have accomplished this achievement. But, for the monkeys that achieved this accolade, we blame it on random luck which we know exists. Yet, how many of us represent to our clients a presumption of skill for selecting the fund we are recommending (without knowing the factual cause) even though a slightly higher percentage of monkeys would randomly produce this result?

Nor do I find it ironic that the five-star rated American Funds Fundamental Investor Fund outperformed both the S&P500 and the category average five of the last six years, an achievement reserved for only the top 11% of monkeys.

Now step back and think about this for a moment. We know for a fact that random luck exists. We know the cause of outcomes for random coin flips is provable math. We also know that skill might exist. We cannot definitively say that a superior result was caused by skill. In fact, if our attempt to prove skill relies on a track record that could have been created with random coin flips, one must acknowledge that any track record could be the result of EITHER skill OR luck.

Our industry tends to ignore these facts. It makes for good marketing and persuasive sales presentations. But, in a practice that is beyond reproach, the emphasis would not be on an ASSUMPTION of skill or a PRESUMPTION of the record being replicated in the future. Instead, it would be fully disclosed and acknowledged as uncertainty for the underlying cause of the observation, and thus unpredictability of the future. Check yourself on this in each presentation you make. Regardless of the disclosures you make, do you IMPLY the record is repeatable in the future, extraordinary or due to skill? If so, is that consistent with the notion of integrity? Do you REALLY know the cause was not luck?

I’ve heard pitches from many salespeople peddling various products based on such records. When I hear this I ask them a simple question, “Are you saying this is definitely an indication of future results?”

They all know they would get into trouble from a regulatory perspective if they said it was. But, their usual retort is something like, “if you don’t go on track records, what else do you have to go on?”

And my answer is, “if track records are uncertain, unknowable for future results and replicable by random monkeys, why should I care about it?”

Acknowledging this reality and clearly communicating it exemplifies a practice that is beyond reproach.

David B. Loeper is the CEO of Financeware, Inc. which does business as Wealthcare Capital Management. An SEC Registered Investment Adviser with nearly 25 years experience, Loeper has appeared on CNBC and has been a featured contributor on Bloomberg TV and CNN.

Loeper joined Wheat First Securities as vice president of investment consulting in 1988, where he served for 10 years. He was promoted to managing director of investment consulting, and then eventually to managing director of strategic planning for the retail brokerage division. He left his position at Wheat First Securities in 1999 to found Financeware.

Loeper has been a member of the Investment Management Consultants Association (IMCA) for over 20 years, serving on the advisory council for more than 5 years, most recently as chairman. Loeper was also appointed by the governor of Virginia to serve on the Investment Advisory Committee of the nearly $30 billion Virginia Retirement System. He received his CIMA® designation in 1990 by completing a program offered through Wharton Business School, in conjunction with IMCA.

Loeper has authored numerous whitepapers and books including the top selling book, Stop the 401k  Rip-off! as well as  The Four Pillars of Retirement Plans, Stop the Retirement Rip-off and Stop the Investing Rip-off