Michael Mauboussin, professor at Columbia Business School and managing director of global investment strategies at Credit Suisse, opened up the annual Morningstar Investment Conference in Chicago this week with an examination of the interplay between skill and luck.
Turns out the latter is much more responsible for exceptional performance, as well as performance that lags, than we care to admit, whether it be in sports, gambling, business – or investing, at least in the short-term. For those chasing the most recent performance, recognition that luck is often dictating results on the margins can perhaps lead investors to understand what will happen when that luck runs out, as it always does.
Not to say skill is a negligible factor – in fact, Mauboussin made the case that the more skill involved in any endeavor readies the ground for luck to flourish.
Consider marathon runners. It’s no surprise that marathon runners have, over 70 years, finished races faster than they have in the past. For all kinds of reasons, marathon runners, like all athletes (and investment managers) are simply better than they were decades ago.
What’s more surprising is that the time difference between the first place runner and the twentieth place runner has dramatically shrunk over that same time period: 39 minutes separated the two in 1932, only 7 in 2012. Not only do top athletes get better, there are more of them. The deviation between their performances narrows and in absolute terms, it gets harder to stand out from the pack. In that sense, the ‘victory’ of being first looses some of its luster, and it could be argued it is far more attributable to luck than skill. And everyone’s got skill.
The trouble is, thanks to “creeping determinism” and “hindsight bias,” we attach stories to those events to create narratives that allow us to explain them. Consider the Mona Lisa by Leonardo Da Vinci. Why is it the most famous painting in the world? Perhaps because of its subtle play of light, the mysterious smile across the subject’s face, the innovative brush strokes in the background giving the illusion of movement.
But in reality, the painting was for years not considered great. Only after it was stolen and, after two years, recovered to much fanfare and publicity did it’s fortune as the world’s most recognized painting rise.
Or consider Stephen King: The novels he wrote under the pseudonym Richard Bachman were, by commercial standards, failures. That is, until someone discovered he was indeed the author. Same writing, same skill, same genre. Why is the real Stephen King successful while the pseudonymous Richard Bachman not? “I would call that luck,” says Mauboussian.
“Once something happens, you begin to create a story quickly and spontaneously that explains what happens and sees it as inevitable,” he said. “We are hardwired to not think about luck. People believe these narratives and change their behavior.”
So too with investing. Funds that have outsized performance are often benefitting from luck, not skill, and will, inevitably, return to the mean.
Which is not to say skill plays no role. In an interview with reporters after his talk, Mauboussian pointed out that one way to determine skill in active stock picking is to see how far an active portfolio differs from its benchmark index. If it’s similar, there’s little skill involved and why pay for a closet index fund? If it differs fundamentally, and yet retains little “tracking error” from the performance of the index, there is some skill involved.
It may never be possible to determine how much luck versus skill went into any success. But luck plays a larger role than we usually admit, so investors would do well to try and identify it when they can.
Mauboussian’s recent book is The Success Equation: Untangling Skill and Luck in Business, Sports and Investing.