FORTUNE — Pimco’s founder “The Bond King” Bill Gross once quipped that “anyone can theoretically roll 12 sevens in a row.” According to Barron’s in early 2003, he was talking in passing about the then-reigning ruler of stocks, Legg Mason’s Bill Miller, who at the time had beaten the S&P for the previous dozen years.
It was a powerful statement about luck vs. skill from the formidable fixed income guru. Clients might ask if they could apply the same words to Gross, too.
Similar to Miller, Gross has outperformed his peers in the bond market for years. But as the market blinked, Gross’s investments struggled. An ill-timed bet on U.S. Treasuries last year made the Pimco Total Return Fund post a loss. Investors pulled out some $40 billion. Most recently, some internal bickering with former CEO Mohamed El-Erian, aired in unseemly ways through press reports, has raised questions about Gross’ ability to bounce back.
Gross wouldn’t be the first person to draw parallels between hot hand streaks and investment success. Economists often use a coin toss analogy to discuss whether the world’s most sophisticated risk takers are actually good at their trade, or if they’ve simply played the game too few times to tell.
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“Essentially, the problem with assessing any individual manager is disentangling some luck,” says Brad Barber, the Gallagher Professor of Finance at UC Davis and co-principal investigator for the CalPERS Sustainable Research Initiative. When academics look at coin tosses, “you’ll always get streaks of tails or streaks of heads.” When applying this to investing, “the question is whether this is more or less than you would expect by chance.” Focus on the folks that have streaks, he said, and there is little evidence skill, rather than luck, helps them outperform.
Barber explains the odds like this: With four tosses, the odds of four heads is one in 16. If there are 2,000 mutual funds with 4-year track records, then 125 funds would “beat the market” by chance (one divided by 16 multiplied by 2,000). After 10 years, about two out of 2,000 funds would have 10-year winning streaks by chance. (At the end of last year, there were over 7,500 mutual funds.)
Several studies support Barber’s assertions. An in-depth statistical analysis from the University of Chicago in 2010 found that few managers have enough skill to simply cover their costs. A 2009 study from several professors including Scott Stewart of Boston University found that institutional investors lost some $170 billion for clients between 1984 and 2007 because of bad decisions. “Much like individual investors, who seem to switch mutual funds at the wrong time, institutional investors do not appear to create value from their investment decisions,” the study said.
Michael Mauboussin, former strategist for Legg Mason and current head of global financial strategies at Credit Suisse (CS), disagrees. Mauboussin has written several books trying to explain the difference between skill and luck — particularly as it pertains to the few superstar managers. He says that if you can’t lose on purpose, then you can’t win on purpose either. A more appropriate comparison is basketball or other games that require both skill and luck. Poor players could statistically speaking experience winning streaks (think Jeremy Lin’s performance in 2012 with the Knicks), but consistent streaks by a handful of performers suggest that skill is involved (Wilt Chamberlain).
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In his book More Than You Know: Finding Financial Wisdom in Unconventional Places, Mauboussin writes, “We can only hope that Gross, who has a great investment track record and familiarity with gambling, was misquoted: The odds of rolling twelve sevens in a row are approximately 1 in 2.2 billion.”
A few years after Gross’ comments, Miller’s hot hand went cold. He beat the market for 15 years, but starting in 2006, he grossly underperformed. In 2012, he stepped down from his main fund and took a lesser role at Legg Mason. This spring, he will start to manage a fund with his son. With only one shaky year, Gross still reigns in bonds. Only time will tell if his fortunes have been the product of a lucky streak or if they are representative of real skill.
