In How social influence affects our decisions, we dabbled with Michael Mauboussin’s thoughts on luck and skill in investing. Here we dig deeper as he explains where investing sits on the skill/luck continuum.
Given our own human proclivity to seek out causality, we tend to underestimate the role that luck can play.
1. Acknowledge the “luck” factor.
The main point is to think critically about the activity you’re participating in and consider how much luck contributes to the outcome. In some realms it’s negligible, such as a running race. But in others, it’s huge.
Once you understand luck’s role, you can understand how to approach the activity more thoughtfully, including how you develop skill and interpret results.
Our minds are horrible at understanding luck. So any mental model has to overcome our natural tendency to think causally—that is, that good outcomes are the result of good skill and bad outcomes reflect bad skill.
2. On the luck-versus-skills spectrum, determine where investing falls.
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 particularly interesting one.
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.
I would place investing 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.
3. Investors tend to systematically overestimate the roll of skill and underestimate the role of luck in their investment decisions.
This reminds me of something Victor Hugo said: “The mind, like nature, abhors a vacuum.” It is psychologically extremely difficult to attribute something to luck. The reason is that in the left hemisphere of our brains is a part that neuroscientists call the “interpreter.” The job of the interpreter is to create a cause for all the effects it sees. Now in most cases, the cause and effect relationships it comes up with make perfect sense.
Throw a rock at a window and the window smashes. No problem. However, the interpreter doesn’t know anything about luck. It didn’t get the memo. So the interpreter creates a story to explain results that are attributable solely to luck.
The key is to realize that the interpreter operates in all of our brains all of the time. Almost always, it’s on the mark. But when you’re dealing with realms filled with luck, you can be sure that the interpreter will create a narrative that is powerful and false.
In investing, for example, we try to attach a cost and reason to the performance of our portfolio. 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. 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.
4. An emphasis on only skill leads to behavioural traps.
Overconfidence. A belief that you know what the future is going to hold to a greater degree than you 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.
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.
5. Employ tactics to combat bad behavioural tendencies.
Mutual funds
When investing in mutual funds, try to avoid timing because it can really jeopardize your returns. That is why, whatever the market return or the fund return, the average individual investor only earns about 50% to 60% of that primarily because of bad timing.
Focus on process, not individual managers.
Whenever you see an outlier, such as a very long winning streak, it’s likely the result of both extreme skill and extreme luck. What happens following a streak of outperformance can also offer clues as to just how much luck and how much skill was involved. Reversion to the mean after an extreme outcome is expected to happen anytime there is luck involved. The more skill is involved, the less the expected reversion.
Stocks
When analyzing a stock, dig into fundamentals. Look at history, past results and past ranges of outcomes. Sales growth rates. Margins. Stock-price performance. How much do stocks tend to move on average over time?
A more advanced technique is the options market. 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.
Check the competition. Another technique to try to open up your mind to consider more alternatives.
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