Luck and Skill: Can You Tell the Difference

?

Posted by L. C. Chong on May 2, 2014

Source: http://www.morningstar.co.uk/uk/news/109103/luck-and-skill-can-you-tell-the-difference.aspx
Whether in sports or investing, the role of luck in winning streaks is both underappreciated and increasing, said Credit Suisse managing director and author Michael Mauboussin during the kick-off keynote at the 2013 Morningstar Investment Conference in Chicago.
Discussing concepts from his latest book, “The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing,” Mauboussin–also an adjunct professor of finance at Columbia Business School–argued that human brains are, in fact, hard-wired to see skill, even when little or none exists.
“Your mind is allergic to randomness,” he said. It wants to create a narrative to explain the effect you’ve seen. This is followed, Mauboussin explained, by a creeping determinism that begins to solidify that interpretation as the correct one, as well as a hindsight bias, causing us to believe the outcome was predictable all along.
He pointed to the interesting case of the Mona Lisa. Why is it the most famous painting? Some may point to Da Vinci’s skill or technique, or the compelling expression on the subject’s face. But Mauboussin explained that for most of its existence, the painting actually wasn’t the most famous, or the most expensive, being valued only at about one-sixth of most famous paintings in the mid-1800s. What changed? No one knows for sure, but Mauboussin posits that the theft and subsequent recovery of the Mona Lisa in the early 1900s did a lot to raise the painting’s profile.
The opinions of others can also play into perpetuating the success of one thing over another, despite the skill involved. For instance, Mauboussin cited a Columbia University study that allowed users to rate songs by unknown bands. One song was ranked No. 26 by raters who couldn’t see the ratings of other participants, while it was rated No. 1 in another group that could see others’ opinions, and No. 40 in a third such group.
So if skill and luck are so hard to untangle, how can we really tell the difference? Mauboussin offered a few reality checks to assist. Whenever you see an outlier, such as a very long winning streak, it’s likely the result of both extreme skill and extreme luck. Why? Consider the case of sports: Not all skillful players will have winning streaks, but all streaks are made by skillful investors. As a result, luck or randomness must be at play in the differing outcomes among those skilled athletes.
What happens following a streak of outperformance can also offer clues as to just how much luck and how much skill was involved. Reversion to the mean after an extreme outcome is expected to happen anytime there is luck involved, Mauboussin said, but the more skill is involved, the less the expected reversion.
The other issue is that skill is not a static quality–it can go up among a population over time, or decline as an individual ages. For instance, Mauboussin explained, our cognitive performance is a combination of crystallised intelligence (the knowledge base you build over time) and fluid intelligence, which dictates how you deal with novel situations. While crystallised intelligence rises throughout life, fluid intelligence peaks in our 20s. Mauboussin pointed to studies by Harvard’s David Laibson showing that the peak age of financial decision-making is 53 years old. Why not older? As we age, sometimes we get cognitively lazier, relying on preconceptions and spending less time working through the details and checking our work. The upshot: even when you find skill, it likely won’t persist.
On the flipside is the rise in skill that can happen over time to a group, such as the improvement over time in marathon runners’ race times, which, Mauboussin explained, can lead to a paradox of skill: As skill improves, luck becomes more important in the future outcome variance. For instance, as marathon runners got faster over the decades, the standard deviation among them also went down–the difference between the finish time of the first-place runner and the 20th place runner shrunk.  Because the runners are more tightly bunched, any streaks of outperformance are more likely to be attributable to luck versus skill differences.
Applying these concepts to investing, Mauboussin said that well-equipped financial institutions are increasingly competing against other well-equipped financial institutions, not mom and pop investors. As such, standard deviations are coming down, and it’s much less likely you will see the kinds of streaks you used to. And when you do, luck may be playing a bigger role.
Mauboussin argued that as investors, we need to focus on process, not individual managers, understand where the activity of investing sits on the skill/luck continuum, and, given our own human proclivity to seek out causality, never underestimate the role that luck can play.
- See more at: http://www.morningstar.co.uk/uk/news/109103/luck-and-skill-can-you-tell-the-difference.aspx#sthash.PUm6PYoS.dpuf