Differentiating Skill and Luck in Financial Markets with Streaks

Abstract

Determining whether an individual money manager’s success encompasses any skill is a difficult task. Long financial streaks – successive years in which fund managers are able to outperform the S&P 500 index – can provide new insight into determining whether differential skill plays a role in investors’ returns. Using a data set of the returns of approximately 5,500 different mutual funds from 1962-2008, we obtained an empirical record of financial streaks. We compared the empirical streaks to 10,000 realizations of a null model in which skill plays no role. We find that the empirical record has significantly more streaks than expected based on the null model. This difference implies differential skill among investors, with some funds having a higher likelihood of beating the market from year to year and collectively increasing the number of long financial streaks above the statistically expected amount based on randomness alone. In addition, adding a skill component to the null model generated an outcome that closely fit the empirical results.

Keywords: mutual funds, persistence, fund, streaks, skill, luck

JEL Classification: G10, G12, G14