Michael Mauboussin is considered an expert in the field of behavioral finance and has some famous books on the topic including, Think Twice: Harnessing the Power of Counterintuition and More More Than You Know: Finding Financial Wisdom in Unconventional Places.

michael mauboussin

There are two aspects to success in investing: proficiency and choosing an attractive game. The key to an attractive game is dispersion in skill, where more skillful participants can benefit at the expense of less skillful ones.

The paradox of skill says that in activities where results combine luck and skill, luck is often more important in shaping outcomes even as skill improves. In many competitive interactions it is the relative level of skill that matters, not the absolute level of skill. In many fields, including investing, the dispersion of skill is shrinking, which leaves more to luck.

There is a positive correlation between the breadth of opportunities and the dispersion of fund returns. Pockets of inefficiency persist. These include diversity breakdowns, institutions competing with individuals, and trading with distressed counterparties.

Jim Rutt, formerly both the chief executive officer of Network Solutions and chairman of the board at the Santa Fe Institute, recently gave a talk about his experience in business. He mentioned that he played a lot of poker when he was young, became pretty good at it, and made some money.

Rutt assumed that the best way to ensure continued success was to improve his skill, so he worked diligently at honing his game by learning the probabilities for each hand and studying other players for clues about the strength of their position. At that point, an uncle pulled him aside and doled out some advice. “Jim, I wouldn’t spend my time getting better,” he advised, “I’d spend my time finding weak games.”

Success in investing has two aspects. The first is skill, which requires you to be technically proficient. Technical skills include the ability to find mispriced securities (based on capabilities in modeling, financial statement analysis, competitive strategy analysis, and valuation all while sidestepping behavioral biases) and a good framework for portfolio construction. The second aspect is the game in which you choose to compete. Some games are highly competitive and others are not. You want to find games where your skill is greater than that of the other players. Your absolute skill is not what matters; it’s your relative skill.

See full PDF here: Alpha and the Paradox of Skill

Via: analystreports