Michael Mauboussin, head of global financial strategies for Credit Suisse, is also author of the book The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing. Here he discusses luck and skill in investing with Morningstar's Director of Personal Finance, Christine Benz. To watch the original video, click here.
Why investors tend to systematically overestimate the roll of skill and underestimate the role of luck in their investment decisions....
There's actually a little part of the left hemisphere of our brains called the interpreter, and whenever we see an effect, for example, performance for our portfolio, we try to attach a cost to it. So, basically, it's this cause-and-effect loop that our minds are trying to close all the time. And whenever we see especially good results, our minds naturally think that that's because of skill.
Basically, the interpreter knows nothing about luck, so we can't really account for the substantial role of luck in investing. So, it's this very interesting natural phenomenon that we all do that when we see success, we associate it with skill, even if luck is the key contributing factor.
How that leads to two big behavioural traps....................
One, I'll say is mostly for money managers and that tends to be overconfidence, so a belief that they know what the future is going to hold to a greater degree than they actually do. And the way that typically shows up is projecting ranges of outcomes that are vastly too narrow, so they don't take into consideration all the possible outcomes.
For individual investors, I think the way it shows up primarily is performance-chasing. We tend to buy things that have done well only to suffer for the subsequent corrections, and we tend to sell things after they've done poorly only to miss the potential rally as a consequence. So, as you know, a very well-known fact, you guys have talked a lot about this, markets have returned, say, 8% or 9% over the longer term, and mutual funds have returned little bit less than that. But the average individual investor only earns about 50% to 60% of the market returns primarily because of bad timing. So trying to get rid of that bad timing I think is one of the best possible ways to improve on the behavioural elements.
Specific tactics to combat those bad behavioural tendencies.........
Look at history, look at past results and look at, for example, past ranges of outcomes. And it could be fundamental things for a company, like sales growth rates or margins or stock-price performance. How much do stocks tend to move on average over time? Another technique I like, which is a little bit more advanced, is going to the options market. So, the options prices reflect ranges of possible outcomes. It's priced into those options, and if you're fairly sophisticated, you can divine those distributions from option prices. So, there are number of techniques that you can use to try to open up your mind to consider more alternatives.
On the luck-versus-skills spectrum, where investing falls in terms of success rates............
On one side of the continuum is pure luck, no skills. So that'd be roulette wheels and so forth. On the other side is pure skill, no luck. It may be like a running race. Almost everything in life is somewhere between those two extremes. Investing is a particular interesting one. By the way, there is a really cool test as to whether there's any skill in activity, and that is ask if you can lose on purpose. If you can lose on purpose, there has to be some skill.
We know that it's hard to create a portfolio that beats a particular benchmark. But actually, given the same parameters, it's pretty hard to build a portfolio that does a lot worse than the benchmark. So that tells you right away that we're toward the luck side. So I would just say, I don't know where to place it exactly. I think it's toward the luck side, but I do want to emphasize, and this is really important, is that every piece of research that's been done on this shows there is differential skill in money managers. There are managers who are more skillful than others. The challenge is primarily figuring out who it is ahead of time.
So, it's not completely on the luck side, and there is a big difference between being mostly luck and all luck. And especially as you expand your time horizons, skill does tend to reveal itself. So, it's toward the luck side, but there is differential skill, and we still should be focused on trying to figure out who those folks are with skill and try to align ourselves with them.
Common attributes skillful managers have........
Great process. This has typically three components to it.
One is an analytical component, which is finding stocks with edge where you have a high expected return. The second is position sizing, so once you have the edge, how do you put it into your portfolio. So, that would be the analytical bucket.
The second would be behavioural--there are slew of these sort of behavioural pitfalls. Are you aware of those? Can you manage those as an investment organization to try to damp down? You can never get rid of them.
The third is what I call organizational, in which every organization has its own constraints and issues. Can we try to understand those things and minimize those things?
Now those are all interesting things, but sometimes as an investor it's hard to see in to figure those things out. So, the question is are there any metrics, any statistics that may help you? And some of the statistics may be helpful and I think, again, it's early days, but something like active share and tracking error. So, active share is looking at how different your portfolio is than your benchmark. It turns out high active share tends to be reasonably associated with good returns, but you don’t want too high tracking error, which is sort of making a lot of factor bets. So it's something that's different than the portfolio via stock-picking but not making big factor bets.
As a group they tend to do a little bit better than others. So, there might be ways to get some insight, and by the way, tracking error, importantly, and active share are within the control of the manager, so that is indicative of skill. So it's the process orientation and then maybe some tip-offs as to who is doing things well from a process point of view.
The original interview has been edited to make it applicable to an Indian audience.
In this very interesting presentation made in Chicago, Mchael Mauboussin talks about this subject in detail.