Investing Skill vs. Luck with Michael J. Mauboussin, Counterpoint Global (Dec 6, 2023)
Is it better to be lucky or good? How much of a role does luck pay in investing? And how can you tell the difference between chance and skill? In this episode of At the Money, I speak with Michael Mauboussin.
Full transcript below.
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About Michael J. Mauboussin:
Michael Mauboussin is head of Consilient Research at Counterpoint Global, Morgan Stanley Investment Management. Previously, he was Director of Research at BlueMountain Capital, Head of Global Financial Strategies at Credit Suisse, and Chief Investment Strategist at Legg Mason Capital Management. He is the author of multiple books about investing, including The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing.
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Transcript: Skill vs. Luck
I’m Barry Ritholtz, and I’m excited to tell you about my new podcast, At The Money. Each week, I’m going to spend about 10 minutes or so diving deep into a specific topic that affects you and your money, acquiring it, spending it, and most of all, Investing it strap in for at the money, starting right now.
(Musical Intro: We’re up all night to get lucky. We’re up all night to get lucky. We’re up all night to get lucky. We’re up all night to get lucky).
I’m Barry Ritholtz. And on today’s edition of at the money, we are going to discuss how to distinguish between skill and luck. And hopefully, how to make better investment decisions.
To help us unpack all of this and what it means for your portfolio, let’s bring in Michael Mauboussin, Head of Conciliant Research at Morgan Stanley’s Counterpoint Global Division. He is also the author of the book, The Success Equation. Untangling skill and luck in business sports and investing, the perfect expert for today’s topic.
Barry Ritholtz: Let’s just start with the big question. A fund manager puts up a couple of quarters of great returns. How can we tell if they’re a great investor or simply a lucky one?
Michael Mauboussin: We can’t. It’s that simple. It is that simple. Um, I think the way to think about this, Barry, is that some activities are very skill laden and very small samples will tell you what’s going on.
Investing is an activity that’s laden with a lot of luck and as a consequence, short track records, short records simply do not reveal what we need to know about skill. So let’s break those down. First off, how do you define skill and how do you define luck? So skill I’m going to define right out of the dictionary, which is the ability to apply one knowledge readily in execution and performance.
So you know how to do something when I ask you to do it, you can do it on cue. Luck is more difficult, by the way. This gets into philosophy pretty quickly, but I’m gonna say luck has sort of three attributes. One, it happens to an individual organization, so it happens to you or your favorite sports team.
Second, is it gonna be good or bad? And I don’t mean to suggest that it’s symmetrical because it’s not, but There’s a positive sign, negative sign possible. And third, and I think this is the crucial ingredient, it’s reasonable to expect a different outcome could have occurred. So if we rewound the tape of time and played it again, you could see a different outcome.
So that I think those are the elements we think about. And there’s another really fun little test, which is ask if you can lose on purpose. So when you’re thinking about an activity, want to know, is there skill? If you can lose on purpose, there’s skill. But if you can’t lose on purpose, it’s all luck. So you think about things like lotteries. Or roulette wheels, or Candyland, the game, is that what it’s called? Candyland, the game you play with little kids. That’s all luck.
Barry Ritholtz: One of the phrases I learned from your book was the paradox of skill. As people get more skilled in an activity, luck plays an increasingly important role in determining outcomes. I’m thinking about a fund manager who wildly outperforms their peers for one year and then goes back to very, very Normal activity. Is that an example of the paradox of skill?
Michael Mauboussin: Not so much. The paradox of skill, by the way, which I learned from Stephen Jay Gould, the eminent biologist, is the idea that, as you said, more skill equals more luck.
But let’s unpack that a little bit. The idea is you can think about skill on two different dimensions. One is absolute skill. And I think we’d agree, look around the world, whether it’s investors or businesses or athletes, right? Skill’s never been higher than it is today. The second dimension, however, is relative skill.
And I think that’s the key ingredient here, which is The difference between the very best and the average person is less today than it was in prior generations. So in other words, excellence or skills more uniform, it’s higher and more uniform. And as a consequence of you and I are competing with one another and we have, we both have very high skill, the outcomes are going to look as if they’re more generated by luck.
So it’s not that we’re not skillful is that luck ends up being the residue.
Barry Ritholtz: You mentioned earlier a couple of quarters of good performance is probably luck. How long does it take to identify if a fund manager is skillful? Are we just waiting for that inevitable crash back to Earth, or is there something else?
Michael Mauboussin: So the first thing to acknowledge is that when we think about luck and skill, you can probably think about it as a continuum, right? So some activities all skill, no luck. Some activities all luck, no skill. Most of the interesting things in life are in the middle. This idea of regression toward the mean, crashing back toward Earth.
This luck skill continuum gives you a really good insight about that. So if it’s all skill, no luck, there’s no crashing back to earth, right? Again, you play Novak Djokovic three matches in a row, he’s going to win every single time. I’m thinking I presume.
Barry Ritholtz: I’m thinking of chess.
Michael Mauboussin: Your skill in chess, running races, okay, those kinds of things. By contrast, if it’s pure luck, you won the lottery yesterday, fabulous, but of course, what you’re probably winning tomorrow is exactly the same statistically as it was before. So you’re going to have complete regression toward the mean. So investing, as it turns out, and again, it’s not because investors are not skillful, it’s because they’re so good at what they do, shows up on the luck side of the continuum as a consequence of regression toward the mean, uh, is important.
So the answer is, when we try to identify where there is skill, we need to focus on process, not just those outcomes. And because there is so much, luck, you have to, you have to look at a fairly large, long period of time to try to sort it out.
Barry Ritholtz: So the average investor is trying to establish a framework to better identify those managers that are skillful versus those that have just been on a hot streak. What can we do to build better decision making? What should they be thinking about?
Michael Mauboussin: I hope this doesn’t get too fancy. By the way, I’ll just mention quickly, long streaks, by the way, are actually very indicative of skill. So a long streak, Joe DiMaggio hitting 56 games, is lots of skill plus lots of luck.
That’s the only way you can get there.
Barry Ritholtz: I was going to suggest Bill Miller, same thing. Very famously, 15 years beating the S& P 500.
Michael Mauboussin: That’s basically the only way you can get there. So there are methods to do this, Barry. And by the way, the key is you can think about this in whether you’re doing a mutual fund or even, you know.
A buyout fund or venture capital, and there’s something called the fundamental law of active management. We won’t get into this in any great detail, but it basically says your excess return, so succeeding, is a function of your skill, which we can break down in terms of things like batting average, which how often you’re right, and slugging average, how much you make when you’re right, times.
Basically, dispersion, how, how the, there’s, how much variance there is in, in the assets that you’re trying to invest in. And so you can, you can break down different ways to get good excess returns. And they’re different for different asset classes. By the way, you think about venture capital, very low batting average, but very high slugging, right?
And you think about. Renaissance technology, quants, right, very, very low batting average, slightly over 50 percent batting average, not making a lot on each investment, but wildly successful over time. So there are ways to try to, to map structure into thinking about evaluating skill.
Barry Ritholtz: This isn’t just about Investing, you identify similar issues in business, in sports. What is it about the combination of skill and luck that’s so challenging across all these different fields?
Michael Mauboussin: It’s fascinating. If you look at professional sports, and it’s not just sports where there’s a salary cap, they’re all grinding toward parity.
The teams are becoming more similar to one another. Why is that? It’s because the athletes themselves have gotten uniformly great. So you think about sports leagues, the evolution of the NBA or the evolution of the Premier League and, and, and, uh, and soccer, those used to be kind of regional leagues with not that many players.
Now they’re all global, lots of money. Amazing training techniques, great analytics, right? You’re bringing the best together with all the resources. And as a consequence, everybody’s really, really good. And so parity becomes more important than ever before.
Barry Ritholtz: So let’s bring this back to investing. I’m thinking about hiring a fund manager to run my company’s 401k. How do I go about evaluating a manager or an advisor to identify whether or not they’re really talented or if they just happen to have gotten lucky?
Michael Mauboussin: Yeah, the answer is you have to focus on process and so you want to think to yourself, what process do you think makes a lot of sense, right? Is it economic?
Is it repeatable? Is it sensible in ways that can be explained?
Barry Ritholtz: To me, though, focusing on process is the best answer to that question. And when you describe about repeatable and sensible, that kind of eliminates some of the wackier. Forms of temporary, um, performance creation that are much more likely to disappear.
I’m thinking about some astrology funds and some other kind of wacky funds that the basis makes no sense. But for a while, they put up spectacular numbers before literally crashing back to Earth.
Michael Mauboussin: That’s exactly right. Yep. So let’s talk a little bit about lucky investors and skillful investors. Do the lucky investors admit when they hit the lottery?
And what do skillful managers say when they’re on a good streak? I do think most really good investors acknowledge the rule of luck. And so, you know, I think if people are circumspect, they absolutely do. But I’ll just mention, Barry, there’s a new paper, which I love, that has a stat in there, which I found to be fascinating.
This is a guy that used machine learning program to study the attribution of mutual fund performance. And so they’re like, if, if, you know, if a stock did well in my portfolio, what, how much was internal versus external? And if it was internal, if it was a successful stock, it was 59 percent of the, it was internal basically.
Right. I’m a smart guy for those where it was a detracting stocks. It was a bad performing stock in those instances. Eighty three percent external, right? So this is what we call the self attribution bias. When things are good, it’s because I’m smart, and when things go badly, it’s because the world out there is messed up and I got unlucky, basically.
So I do think broadly speaking, people are not good at this. Broadly speaking, people want to think of their successes as a function of their own skill. But again, most people who really think it through recognize the extraordinary role of luck.
Barry Ritholtz: Classic human nature, behavioral biases. What other challenges surrounding Locke are worth mentioning for the investor trying to figure out how to allocate their portfolios.
Michael Mauboussin: Yeah, I think one aspect of luck that’s not fully appreciated is that it almost comes in two flavors. Um, the first flavor is sort of things that are independent, you know? And by the way, one example we used is baseball hitters, you know, so if you hit over season two 50 or 300, like, you know, what, what are the streaks look like?
And so that looks really like a spinner model, almost like a coin tossing type of model. So one event is, is distinct from the other. The second kind of luck is really the cumulative process. And so what happened before leads to what happens next. And that’s really important when you think about social.
Products like sales of books, sales of, you know, popular TV shows, sales of films, that type of stuff. So this independent versus cumulative thing, I think, is a really big factor that people sometimes don’t think about as clearly as they could. Maybe the other thing I’ll say, Barry, is I sometimes see this that people go, you know, How do I become a luckier person?
And here are four things you need to do to become luckier. It doesn’t make any sense. You can’t make your own luck, right? By definition, it’s something out of your control. Now, what you can do is put yourself in a position to have luck. Buying a lottery ticket will do that for you. That doesn’t mean you’re going to have good luck, right?
So this is the key. And putting yourself in a position to be lucky might be a skill in and of itself, right? So it’s not really luck. So that breakdown of what’s in your control, what’s not in your control, I think is a very important thing for people to bear in mind.
Barry Ritholtz: So to wrap up, investors who are entranced by a manager with an unusual hot streak should always ask themselves the question, is this the result of a purposeful repeatable strategy or process, or is it just dumb luck?
If you can’t tell the difference, Well, don’t assume you’ve stumbled on to the next Peter Lynch or Warren Buffett. If it looks lucky, it probably is.
[Music: We’re up all night to get lucky. We’re up all night to get lucky. We’re up all night to get lucky. We’re up all night to get lucky. We’re up all night to get lucky.]
You can listen to At The Money every week. Find it in our Masters in Business feed, at Apple Podcasts. Each week, we’ll be here to discuss the issues that matter most to you as an investor. I’m Barry Ritholtz. You’ve been listening to at the Money on Bloomberg Radio
Michael J. Mauboussin Authored Books
The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing by Michael J. Mauboussin
Expectations Investing: Reading Stock Prices for Better Returns, Revised and Updated by Michael J. Mauboussin and Alfred Rappaport
Think Twice: Harnessing the Power of Counterintuition
More Than You Know: Finding Financial Wisdom in Unconventional Places
