Untangling luck and skill in investing

What is the ratio of luck to skill in the following pursuits: picking lottery tickets, running a race and investing?

Most people would say that picking lottery tickets is all luck. And that the result of a running race is all ability. But what about investing?

The best-known expert in this area is Michael Mauboussin, whose fascinating book, The Success Equation, analyzes luck and skill in sports and in investing.

Mr. Mauboussin first analyzes team sports. He begins by plotting on a graph the results that would be achieved by NFL teams if the result were determined entirely by luck. As those who have studied statistics might expect, the line produced by randomness is a bell-shaped curve.

Pivoting to the assumption that only skill matters, he then plots the result that would be achieved if we were to assign different levels of skill to each team and the more skilled team won every game. The result of this skill-only assumption is a horizontal line.

Then Mr. Mauboussin compares the actual results achieved over several NFL seasons with his two studies and concludes that the result in an NFL game is determined roughly 52 per cent by skill and 48 per cent by luck. (Further studies reveal that basketball games are more skill-based than football whereas hockey is more luck-based.)

You may be wondering whether this ratio of skill to luck in sports has been constant through the years. Studies show that, over time, while the absolute performance of athletes has improved, the relative performance of the winner has declined. For example, the difference in time between the fastest and 20th fastest marathon runner in the Olympic Games has significantly decreased.

In almost all sports, the difference between the best player and the median player has dropped, owing to what has been called the paradox of skill. Essentially, as all athletes get better at their sport, the difference between the best player and the average player decreases.

In any competitive endeavour that involves both luck and skill, as the difference between the top competitor and the median competitor declines, skill becomes less important and the role of luck increases.

Investing in the stock market, like sports, is a competitive activity. Every time you buy or sell a stock, someone is on the other side of that transaction. On each trade, only one of you can be the winner.

Turning to investing, Mr. Mauboussin examines the results of more than 1,400 mutual funds, comparing their results between two successive three-year periods. He discovers a surprisingly low correlation between performance achieved by each fund in the two three-year periods. Plotting these returns on a graph would result in a picture far closer to a bell curve than a horizontal line. Mr. Mauboussin concludes that success in investing, measured over a three-year period, is an activity that is about 85 per cent luck and only 15 per cent skill.

It’s not that investors – be they professional or retail – lack skill. The result is explained by the paradox of skill – as investors have become more sophisticated and have more information available to them, the variation in ability has shrunk and results have been increasingly determined by luck.

But here’s the thing. The importance of skill varies directly with the time period studied. Results over periods of less than three years would be even more determined by luck, whereas longer-term outcomes would be more determined by skill. A 10-year track record tells you far more about a firm’s ability than a five-year track record.

The important role of randomness in investing is not bad news for serious investors. Skill does have an important role to play – but only in the long run. If you are an investor, it’s important to take a long-term view, and tilt the odds in your favour.

In any activity that involves both luck and skill, such as bridge, poker and investing, you should focus not on recent results, but rather on process – procedures that have proven, over time, to work. Mr. Mauboussin identifies several of these.

Thinking in terms of probabilities is not intuitive, but it is useful. Given our instinct to focus on whatever we have most recently looked at, it’s helpful to step back and take a wider perspective – what some call taking an outside view. For example, when forecasting future profits of a company, don’t restrict your research to how the company has grown earnings over the past few years. Instead, ask, for example, how companies of about that size, and in the same industry, have done over the past 10 years. Your final decision should be based on a synthesis of the two approaches.

Another helpful procedure is to be rigorous in your use of checklists to ensure you perform all the necessary tasks before a buy or sell decision. There’s a reason airline pilots do this.

Making investment decisions in small, cognitively diverse teams, rather than by a single individual, has also been shown to improve results.

In every aspect of life, randomness (or luck) is a far more important force than most people realize. Recognizing its role in investing will make you a better investor.

Biff Matthews is the chairman of Longview Asset Management Ltd., a Toronto-based investment management firm.