Probabilistic Approach to Recent Winners: When evaluating someone’s alpha or outperformance, it’s essential to dig deeper and ask: Is it purely due to stock picking, or is it a result of being in the right place at the right time?
Michael J. Mauboussin, in his book The Success Equation, differentiates between luck and skill, a concept that is well-known internationally.
As money managers for institutions, one of the first things we examine is how much of your alpha stems from being in the right market at the right time, and how much comes from skillful stock picking, regardless of the market segment.
It’s recognized that alpha generated from stock picking is a function of competence—your skill—while alpha from being in the right market segment is largely a matter of luck.
Chasing past performance is also a deterministic behavior, implicitly suggesting, “What has worked so far will continue to work.”
Therefore, when considering a past performer, it’s crucial to understand what drove that performance.