Everyone believes they are above-average drivers and most investors believe successful investing can be attributed to skill. Michael Mauboussin, author and Chief Investment Strategist at Legg Mason Capital Management, tackles the issue of how important a role luck plays in various professional activities, including investing (read previous IC article on Mauboussin) in his meaty 42-page thought piece, Untangling Skill and Luck.
Skill Litmus Test
Whenever someone becomes successful or a sports team wins, doubters often respond with the response, “Well, they are just lucky.” For some, the intangible factor of luck can be difficult to measure, but for Mauboussin, he has a simple litmus test to evaluate the level of skill and luck credited to a professional activity:
Welcome to our latest issue of issue of ValueWalk’s hedge fund update. Below subscribers can find an excerpt in text and the full issue in PDF format. Please send us your feedback! Featuring hedge funds avoiding distressed china debt, growth in crypto fund launches, and the adapting venture capital industry. Q3 2021 hedge fund letters, Read More
“There’s a simple and elegant test of whether there is skill in an activity: ask whether you can lose on purpose. If you can’t lose on purpose, or if it’s really hard, luck likely dominates that activity. If it’s easy to lose on purpose, skill is more important.”
Mauboussin uses various sports and games as tools to explain the relative importance that skill (or lack thereof) plays in determining an outcome. At one extreme end of the spectrum you have a brain game like chess, in which a skillful chess pro could beat an amateur 1,000 times in a 1,000 matches. In the field of professional sports, at the other end of the spectrum, Mauboussin hammers home the relative significance luck contributes in professional baseball:
“In major league baseball the worst team will beat the best team in a best-of-five series about 15 percent of the time.“
Here is a skill-luck continuum provided by Mauboussin:
Source: Legg Mason Capital Management
Streaks vs. Mean Reversion
Mr. Mauboussin spends a great deal of time exploring the implications of skill and luck in relation to streaks and mean reversion. In the streak department, Mauboussin uses Joe DiMaggio’s record 56-consecutive game hitting stretch. He acknowledges the presence of luck, but skill is a prerequisite:
“Not all skillful performers have streaks, but all long streaks of success are held by skillful performers.”
When detailing streaks, Mauboussin may also be defending his fellow Legg Mason colleague Bill Miller (see Revenge of the Dunce), who had an incredible 15 consecutive year of besting the S&P 500 index before mean reverting back to lousy human-like returns.
This is a nice transition into his discussion about mean reversion because Mauboussin basically states this reversion concept dominates activities laden with luck (as shown in the Skill-Luck Continuum chart above). Time will tell whether Miller’s streak was due to skill, if he can put together another streak, or whether his streak was merely a lucky fluke. Unlike the judicial world, investment managers are often treated as guilty until proven innocent. For now, Miller’s 1991-2005 streak is being treated as luck by many in the investment community, rather than skill.
Nobel-prize winner Paul Samuelson may believe differently since he concedes the existence of skillful investing:
“It is not ordained in heaven, or by the second law of thermodynamics, that a small group of intelligent and informed investors cannot systematically achieve higher mean portfolio gains with lower average variabilities. People differ in their heights, pulchritude, and acidity. Why not their P.Q. or performance quotient?”
Peter Lynch’s +29% annual return from 1977-1990 is another streak on which historians can chew (read more on Lynch). I, like Samuelson, will give Lynch the benefit of the doubt.
Creating a Skillful Analytical Edge
Unlike the process of mowing lawns, in which more applied work time generally equates to more lawns cut (i.e., more profits), the investment world doesn’t quite work that way. Many people could work all day, stare at their screen for 23 hours, trade off of useless information, and still earn lousy returns. When it comes to investing, more work does not necessarily produce better results. Mauboussin’s prescription is to create an analytical edge. Here is how he describes it:
“At the core of an analytical edge is an ability to systematically distinguish between fundamentals and expectations.”
Thinking like a handicapper is imperative to win in this competitive game, and I specifically addressed this in my previous Vegas-Wall Street article. Steven Crist sums up this indispensable concept beautifully:
“There are no “good” or “bad” horses, just correctly or incorrectly priced ones.”
A disciplined, systematic approach will incorporate these ideas, however all good investors understand the good processes can lead to bad outcomes in the short-run. By continually learning from mistakes, and refining the process with a constant feedback loop, the investment process can only get better. On the other hand, schizophrenically reacting to an endless flood of ever-changing information, or fearfully chasing the leadership du jour will only lead to pain and sorrow. Fortunately for you, you have skillfully completed this article, meaning financial luck should now be on your side.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing, SCM had no direct position in any other security referenced in this article. Radio interviews included opinions of Wade Slome – not advice. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is the information to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.