Skill Versus Luck in Investing

Have you ever looked through a kaleidoscope? You know, one of those tube-shaped objects with mirrors and colored glass that make beautiful patterns when you rotate it? I'm going to ask you to try looking at your world differently, and consider the various roles that luck and skill play in almost every outcome. We're going to use a new tool, a "skilleidoscope," that will help us identify where skill is actually present.

In his book, The Success Equation, Michael J. Mauboussin explains how events are affected by both luck and skill, and how to determine the impact of each on an activity or outcome. I highly recommend it to anyone with a curious mind and suggest adding it to your list of mental models. The examples the book cites are delineated by life, business, sports and investing. As a financial planner, I am primarily interested in how Mr. Mauboussin's conclusions apply to the world of investing.

Over the last few decades, theories in finance have focused on identifying factors that are predictable and can help us decide which particular investments give us a better chance at succeeding. Succeeding in investment management usually means getting a return commensurate with the risk we bear or a better return than what is expected by comparing to a reliable benchmark.

The biggest controversy these days is the "active versus passive" debate. Passive is defined as low-cost, highly liquid investments such as index mutual funds and low-activity exchange traded funds (ETFs). These funds generally require little day-to-day management and generally just try to match a published index. Therefore, their management fees are very low.

Active funds involve managers and teams attempting to do better than their benchmarks through different strategies, such as using sector weighting, focused portfolios, segments of the market, style investing, global investing, etc. They tend to have relatively high management fees. The argument is that if you are paying those higher fees, you should expect better results. Otherwise, why spend the money paying for active management? And that is a common sense position, particularly when you realize that over periods of time, very few actively-managed funds outperform their benchmarks.

The Success Equation attempts to break out the element of skill from luck in investing. The author has developed what he calls the "luck versus skill continuum," as shown below, based on extensive statistical analysis.

Thinkstock

You can readily see where investing fits on this scale—unfortunately near the "pure luck" endeavors (as is the world of business, where he makes the case that a CEO experiencing success at one firm is hardly assured of success at his or her next venture).

Some of the factors that influence our perception of success in investing include the following:

1. Time frame: Someone with a lousy process can end up winning in the short run due to pure luck. Our tendency is then to project this lucky outcome into the future, and the probability of failure is the same as it was prior to the last "success."
2. Bad luck overcoming skill: An accomplished money manager with a thorough and informed process can fail in the short run due to events outside of his or her control (i.e. dividend stocks gain favor at the expense of non-dividend payers; interest rates affect the market; investors run the technology sector through the roof at the expense of more solid companies; market sentiment shifts to small companies; etc.).
3. Limitations of good luck: A manager possessing a high skill level and is the beneficiary of good luck is suddenly faced with the eventuality of that luck running out. His or her returns are bound to revert to the mean or average.
4. Confusing compensation with skill: Incentives and rewards can reinforce a bad process. Think of the manager who is compensated for return and associates the return with skill when it is really the result of a lucky stretch for his or her style of investing (i.e. internet stocks in the late '90s and the proponents of "new and better" valuation metrics).

Added to the fact that we have largely efficient markets, we also have an increasingly growing pool of highly-skilled talent in the investment business. It is therefore becoming extremely difficult for any one manager to outperform his or her benchmark on a consistent basis.

At a meeting in Chicago last year, I had an opportunity to ask Dr. Eugene Fama, the father of the efficient market hypothesis, how we can explain those few standouts, such as Warren Buffet, if the markets are truly efficient and remove any potential for outperformance (amongst all participants combined). He answered that there are those few who have the requisite talent and skill to add value over time, but the problem is that we don't know who they are in advance, nor how long their advantage will last, so trying to select them is an exercise in futility.

So where does this leave us? Is there any hope in finding outstanding managers and investment opportunities? I would answer that there is, but you have to have a repeatable and disciplined process in place, and not deviate from it. Mr. Mauboussin also recommends that you use checklists to stay consistent in your approach.

In conclusion, I highly recommend reading this book and starting to apply its concepts in your everyday life as soon as possible. It will make a profound difference in how you see the world.

Doug Kinsey is a partner in Artifex Financial Group, a fee-only financial planning and investment management firm based in Dayton, Ohio.