The age-old question of how much of investing is luck and how much is skill is actually being quantified these days, and Josh Wolfe of Emerging Tech Report sits down with the author of a new book on the subject.
Michael J. Mauboussin is the chief investment strategist at Legg Mason (LM) Capital Management. Prior to joining LMCM in 2004, Michael was a man aging director and chief US investment strategist at Credit Suisse.
Michael is the author of The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing; Think Twice: Harnessing the Power of Counterintuition; and More Than You Know: Finding Financial Wisdom in Unconventional Places.
Let’s start off with definitions. People always talk about skill and luck, but they don’t know what they actually mean. How do you define skill and how do you define luck?
This is actually really important to get out of the way, because these topics spill into philosophy very fast. So I’m going to take skill right out of the dictionary: skill is defined as the ability to apply your knowledge readily in performance or execution.
So basically, you know how to do something, and when the moment shows up, you can do it. You’re a violinist, the concert starts, you turn it on. You’re an athlete, you perform at a very high level. That is relatively straightforward.
Now, luck is a little bit trickier. I like the definition of luck that has three specific features:
- First, it works for an individual or an organization, so it’s going to happen to you or say your company or your team.
- Second, it could be good or bad. It doesn’t have to be symmetrical, so they’re not necessarily evenly good or bad, but they can be on the positive side or the negative side.
- And the third, and I think a really interesting one is, it’s reasonable to expect something else could have happened. In other words, it’s not the only thing that could have happened to you.
So when those three things are in play, I think that’s where you have luck. I like to think about the world as a continuum from all skill, no luck (chess matches, running a race) to all luck, no skill (roulette wheels, lotteries). The key is that most things in life are somewhere between those two extremes, and where you are on that continuum of skill and luck has enormous implications for how you should think about your decision making and predictions.
So if we look at that continuum and take things like poker, chess, investing, basketball, and baseball—where do they fall on the spectrum?
Chess is an open information game and it tends to be very, very close to the pure skill side of the continuum. In sports, basketball is mostly skill. Tennis is a lot of skill. Baseball is more in the middle. The most random sport in professional ranks is actually hockey.
Shifting from sports, poker is clearly a combination of skill and luck, and then investing is the one that’s probably most controversial. It’s far over toward the luck side. And it’s not because people aren’t skillful, it’s mostly because their skill offsets one another.
Turning to investments, you cite an interesting example in the book involving Playboy Playmates picking stocks...
Yes, a trading platform company came up with a light-hearted way to promote its firm. They went to ten Playboy Playmates and asked them to pick their favorite stocks. And when they tallied up their performance for a year, it turns out they actually did pretty well. In fact, on balance, they did better than professional money managers.
One of the things that always strikes me about this is that it’s hard to imagine any other profession where someone walking off the street could be better than a trained expert—it’s frightening to imagine this exercise with your dentist, doctor, or mechanic!
Of course, one could argue that if we extended such a study to many, many years, I suspect our professional managers would do better than those Playmates, but it illustrates the point that there is certainly a lot of randomness in short samples.
In your book, you talk about a phenomenon you call the paradox of skill. What is the paradox of skill?
The paradox of skill says that as people become more skillful in a given activity, luck becomes more important in determining the outcome. It seems backwards, but more skill equals more luck.
The way I learned about this originally was a wonderful essay written by Stephen Jay Gould, the famous Harvard biologist, who was writing about, of all things, Ted Williams hitting .406 in baseball in 1941. No one has hit .406 since then, and the question is, why?
Gould concluded that because people in general are becoming more skillful, the variance of skill is narrowing. That is, people are becoming absolutely better but the variance of ability has gone down.
In statistical language, Ted Williams was a four-sigma event—his performance was four standard deviations away from the mean. The standard deviation of batting averages in 1941 was around 32%, and today it’s about 28%. A four-sigma event in 2011 equates to hitting .380. That’s still awesome, but a far cry from .406.
Within companies, how much skill is attributable to the organization or the system versus the individual?
That’s another really fascinating topic. Let me actually start with football, and then we’ll talk about a company like GE (GE).
A group of researchers looked at punters versus wide receivers in the NFL. Wide receivers rely on their system—they have to have a good quarterback, they need an offensive line to protect the quarterback, a good coaching staff, etc.
And when wide receivers get traded, going from one team to another, it turns out their performance actually does slip. By contrast punters, who pretty much do the same thing no matter where they are, show no deterioration in performance moving from one team to the next.
A similar study looked at 20 GE executives. GE is known for having some of the best managerial training on the face of the earth. Over a 20-year span, about half of those executives went off to be either CEO or chairman of other large organizations similar to GE, and they tended to do very well—good financial performance and so forth.
The other half though went to organizations that were very different than GE—for example, one guy went from running a division in GE to running a supermarket chain—and in those instances their performance actually was not very good at all. So it’s not the person having the right stuff, it’s really the combination of the individual and the circumstances they find themselves in that makes a difference.