"Separating skill and luck encourages better thinking about outcomes and allows for sharply improved decision making." – Michael Mauboussin, Legg Mason
Michael Mauboussin, a personal hero of mine, was kind enough to reach out to me after reading my blog, "The Investor's Serenity Prayer." Many of the ideas for the blog post were inspired by Mr. Mauboussin's book, "Think Twice." Mauboussin has expanded on some of the topics touched on in "Think Twice" with a new article titled "Untangling Skill and Luck" which can be found in the differentiated thinking portion of Legg Mason's website.
The article goes through numerous examples of how different professions/games (baseball, football, chess, business, investing, etc.) are part skill and part luck, each with varying degrees. To see the proofs, please read "Untangling Skill and Luck". For me, one example that stood out was that in major league baseball the worst team will beat the best team in a best-of-five series about 15 percent of the time. That is more frequent than flipping a coin and landing on heads three times in a row. For teams where skill is even closer, the percentage goes up dramatically. As a point of comparison, if a great chess player played a mediocre chess player 1,000 times, the great chess player would probably win all 1,000. So next time your favorite sports team is a 3-to-1 favorite and they lose, do not shoot the coach. Ask if the opponent just flipped a coin and got heads a couple of times (25% chance or same as 3-to-1 odds).
When thinking of investing positions on the skill/luck continuum, I'm reminded of a conversation with my office-mate from my first job at CIBC Oppenheimer. He told me that investing frustrates him because unlike many other professions he cannot just work harder and make more money. The guy mowing lawns can work more hours, mow more lawns, and make more money. The salesperson can make more cold calls, land more customers, and make more money. Both professions have a high correlation between effort and reward. But the investor can work 24/7 and potentially not make any more money. Clearly there is the chance that working harder will improve returns, but the correlation between effort and success is not nearly as high as a driven person like him would have liked. I believe this fact is another proof of investing's skew towards the luck side of the skill/luck continuum.
So understanding that luck plays a part is goal number one and then trying to understand how much luck is goal number two. Based on Mauboussin's estimates, investing is larger part luck than skill. This is discouraging for us that devote our life to honing our investing skill, but we should not despair that our efforts are in vain. The fact that investing is not pure luck means that skill matters! But as Mauboussin says, "The key is to focus feedback on improving skill. This is a very difficult task in activities where luck plays a big role. For example, this means that in evaluating an analyst or portfolio manager, it is much less important to see how she has done recently (whether her picks did well or her portfolio beat the benchmark) than it is to assess the process by which she did her job. Embracing and implementing this point of view is demanding. And make no mistake about it: the reason to emphasize process is that a good process provides the best chance for agreeable long-term outcomes."
Even though the heart of the article was the in-depth studies of skill versus luck, my favorite part was Mauboussin's thoughts on portfolio management:
"Finding gaps between fundamentals and expectations is only part of the analytical task. The second challenge is to properly build portfolios to take advantage of the opportunities. There are two common mistakes in sizing positions within a portfolio. One is a failure to adjust position sizes for the attractiveness of the opportunity. In theory, the positions in more attractive probability-weighted opportunities should be more prominent in the portfolio than less attractive opportunities. In some activities, mathematical formulas can help work out precisely how much you should bet given your perceived edge. While this is difficult in practice for most money managers, the main idea remains: the best ideas deserve the most capital. The weighting in many portfolios fails to distinguish sufficiently between the quality of the ideas. The analytical part of a good process requires both disciplined unearthing of edge and intelligent position sizing aimed at maximizing long-term probability-weighted return." (By the way, the second mistake mentioned was overbetting through leverage.)
This is Alpha Theory in a nutshell, so it clearly warms my heart to see Mauboussin spell it out so explicitly.