29 Aug The Success Equation by Michael Mauboussin
Is success a result of skill or luck?
Like it or not, we like to believe that our successes are due to our exceptional skills or hard work. At least we know that as long as we improve our skill, the chances of success will be higher. However, Michael Mauboussin said that it depends on the field or activity we are pursuing. A chess player relies on skill but a baseball player would need more luck.
If you believe that all successes are due to skill, the author would say that you are likely acting under self-serving attribution bias:
“It is common for us to attribute success to our own terrific skill, even in endeavors that are determined mostly by luck… On the other hand, we readily attribute failure to external causes, including bad luck.”
3 Rules to place an activity on luck-skill continuum
How to determine an activity is luck- or skill-driven? Mauboussin suggested these 3 ways.
1) Cause and Effect – “If you can easily identify the cause of a given effect, you’re most likely on the skill side of the continuum. if it’s hard to tell, you’re on the luck side.”
2) Rate of mean reversion – “Slow reversion is consistent with activities dominated by skill, while rapid reversion comes from luck being the more dominant influence.”
3) Prediction is useful – “When the predictions of experts tend to be uniform and accurate, skill is the driving factor. When experts have wide disagreement and predict poorly, lots of luck is generally involved.”
If you still find the above criteria difficult to apply, the author have a simple way to determine if an activity is luck:
“There’s a quick and easy way to test whether an activity involves skill: ask whether you can lose on purpose.”
Investing is a Luck activity
Why investing is about luck?
First, the cause and effect is not obvious. What makes stock price go up? The most common answer is earnings. But Mauboussin found that growing ePS had little correlation with stock returns. In other words, growing ePS is not a strong cause for stock returns. If not, then what? There may be many factors leading to the rise of stock prices and it is very difficult to identify the causes.
There are others who believe in the next big thing. I still remember the popular search engines like Alta Vista, Yahoo, Ask Jeeves, Excite, Lycos, Info Seek, Hotbot, and more, before the rise of mighty Google. Who knew Google will dominate the cyberspace at that time? Some of these companies could have done similar stuffs as Google but lacked the luck to succeed. Most people fail to acknowledge the luck factor and someone would cook up a story why Google succeed and why other companies should follow too. Analysts may also spin a convincing story that Company X is the next Google and why you should invest now. Does Company X have the luck which Google had?
“We don’t observe the unsuccessful company because it no longer exists. If we had observed it, we would have seen the same strategy failing rather than succeeding and realized that copying the strategy blindly might not work.”
Second, investment results in the short run means very little. The author shares a story,
“In 2006, TRADINGMARKETS, a company that helps people trade stocks, asked ten Playboy Playmates to select five stocks each. The idea was to see if they could beat the market. The winner was Deanna Brooks, Playmate of the Month in May 1998. The stocks she picked rose 43.4 percent, trouncing the S&P 500, which gained 13.6 percent, and beating more than 90 percent of the money managers who actively try to outperform a given index. Brooks wasn’t the only one who fared well. Four of the other ten Playmates had better returns than the S&P 500 while less than a third of the active money managers did… Investing is an activity that depends to a great deal on luck, especially over a short period of time.”
As you can see, amateurs can have good runs in the market sometimes, regardless if they are skillful. On the contrary, a skillful investor may suffer losses once in a while and even under-perform the index. This goes to say that investing is not just skill and has the luck factor embedded.
Thirdly, prediction has not been useful for the investors’ pockets. Many experts, gurus, analysts and economists make a lot of predictions. But many of these predictions are inaccurate as well. We will go broke if we invest according to every prediction.
“Investing involves a great deal of luck, which we know from the low degree of persistence in the results and from the absence of experts who can consistently forecast where the market is going.”
Mauboussin explained why prediction in financial markets is so difficult,
“Experts are notoriously poor at predicting the outcomes of political, social, and economic systems… But what’s surprising is not their abysmal record but rather that society continues to believe them. The reason the experts are so hopelessly lost is that political, social, and economic systems are complex adaptive systems… complex adaptive systems effectively obscure cause and effect.”
Track your returns over a long time
We learned that an event relying on luck will mean revert over the long run. Investing being a luck activity, requires a large sample size of trades or period of time to determine if your strategy gives you an edge and get a good return in the financial markets. This is why you must track your investment returns over a few years to know whether you make or break. Most people are too lazy to track or stay with an investment strategy long enough to evaluate the effectiveness. Of course, they are unable to improve without receiving feedback from their results.
Focus on the process – Do the right thing
Once you have proven that your strategy gives you an edge in the market, you have to keep to your investing rules. Regardless whether you profit or lose, you have to stick to the rules. Overtime, you will achieve the true returns of your strategy. The author illustrates with the example of Blackjack, but it applies to trading or investing too, (I also did a post about the relation between Blackjack and Trading)
“In other words, in a pursuit such as blackjack, where luck is very important, you have to adopt a process that you can trust and not worry so much about the outcome of each hand or even each session of play. Your only chance of winning is to adhere to the rules that you know work. Your skill can’t change the odds, it can only be applied to make sure that you play the cards properly.”
Another emphasis on process,
“In activities where luck plays a strong role, the focus must be on process… A good process can lead to a bad outcome some percentage of the time, and a bad process can lead to a good outcome. Since a good process offers the highest probability of a good outcome over time, the emphasis has to be on process.”
Invest in unpopular stocks
Mauboussin opined that investors have skill, in fact, too many investors are skillful.
“It’s not that investors lack skill, it’s the paradox of skill: as investors have become more sophisticated and the dissemination of information has gotten cheaper and quicker over time, the variation in skill has narrowed and luck has become more important.”
If everyone is looking at the same stocks and buying the same ones, it is very difficult to make money. When there are little difference in skill, investors have to rely on luck. The other way is to focus on unpopular stocks. Mauboussin found that active share percentage has a slight positive correlation to stock returns. If your portfolio is very different from the index, your portfolio will either outperform or underperform the index. Hence, to beat the market, you cannot buy stocks from the index.
The author has definitely stir some controversies regarding success, and especially in the area of investing which BigFatPurse and her readers are interested in. What do you think? Do you agree investing has an element of luck?