Success in Investing : Skill or Luck ?

<Edited with additional info and video clip >

Investment Success: Skill or Luck?

We always attribute our success in life or any aspect in life ( e.g career development /doing business / investing ) to our skill or performance but does “luck” has any place in these successful events.

If we think that skill ( talent ) play a very important role in investing,, then you may find that some very talented or intelligent people fail in investing ( e.g Newton ), and if you think that investing is purely on luck, then we may have a puzzle to explain the success of great investors like Warren Buffett or Peter Lynn and others in beating the markets for multiple years.

In the short term, maybe luck play as events tends to be in random, but in the long run, the skills will be vital to achieving returns which would beat the market or so call “ Alpha “

Coin Flipping :

The famous coin flipping story from Warren Buffett which imply the luck factors in short term random event :

Buffett draws an analogy between money managers and stock pickers (like him) and participants in a national coin-flipping contest。

Imagine you get 225 million people (the approximate population of the U.S. at the time) to participate in a coin-flipping contest. Each person bets $1 and flips a coin. “If they call correctly, they win a dollar from those who called wrong. Each day the losers drop out, and on a subsequent day the stakes build as all previous winnings are put on the line,” Buffett wrote.

In day twenty, we have 215 people left and with each one have a winning stake of 1 million each.
Those people can probably write a book on ‘How I Turned a Dollar into a Million in Twenty Days Working “.

Although this is just a story on pure luck, in most case people or fund manager would deem the short term luck couple with “ overconfidence “ biases that contributed to their “over perform “ in short term to be skilled.

But how about the long run? Is the Stock Market Efficient?

Below quoted from Wikipedia on Warren Buffet's thought about "Market Efficiency " :

In "The Superinvestors of Graham-and-Doddsville"  an article by Warren Buffett in promoting value investing, published in the Fall 1984, Columbia Business School magazine. It was based on a speech given on May 17, 1984, at the Columbia University School of Business in honour of the 50th anniversary of the publication of Benjamin Graham and David Dodd's book Security Analysis.

The speech and article challenged the idea that equity markets are efficient through a study of nine successful investment funds generating long-term returns above the market index. All these funds were managed by Benjamin Graham's alumni, pursuing different investment tactics but following the same "Graham-and-Doddsville" value investing strategy.

Buffett starts the article with a rebuttal of a popular academic opinion that Graham and Dodd's approach ("look for values with a significant margin of safety relative to [stock] prices") had been made obsolete by improvements in market analysis and information technology. If the markets are efficient, then no one can beat the market in the long run; and apparent long-term success can happen by pure chance only. However, argues Buffett, if a substantial share of these long-term winners belong to a group of value investing adherents, and they operate independently of each other, then their success is more than a lottery win; it is a triumph of the right strategy.

Buffett then proceeds to present nine successful investment funds. One is his own Buffett Partnership, liquidated in 1969. Two are pension funds with three and eight portfolio managers; Buffett asserts that he had influence in selecting value-minded managers and the overall strategy of the funds. 

The other six funds were managed by Buffett's business associates or people otherwise well-known to Buffett. The seven investment partnerships demonstrated average long-term returns with a double-digit lead over the market average, while the two pension funds, bound to more conservative portfolio mixes, showed a 5% and 8% leads.

You may find the full transcript of his talk in below link :

The Paradox of Skill :

This story may be too extreme in relating luck to investing but how about those skilful fund managers with super-fast computer and sophisticated modelling to pick the right stocks and forecasting their future growth.

In the book title “ Incredible Shrinking  Alpha “, the Authors Swedroe & Berkin define the Paradox of Skill as below :

“What so many people fail to comprehend is that in many forms of competition, such as chess, poker or investing, it is the relative level of skill that plays the more important role in determining outcomes, not the absolute level. What is referred to as the “ Paradox of Skill” means that even as skill level rises, luck can become more important in determining outcomes if the level of competition is also rising .”

According to Michael Mauboussin, former Chief Investment Strategist at Legg Mason Capital Management looked at the historical data on the per cent of equity mutual funds that beat the market during Value Trust's 15-year streak. Because the number of equity mutual funds beating the market fell as low as 8% in one year and 13% in another, he estimated the probability of beating the market in the 15 years ending 2005 was 1 in 2.3 million.

The Hot Hand in Investing :

In the Book title " More Than You Know, M Mauboussin also explains the phenomena of “ Hot hand “ in investing. “ Human are natural “pattern seeker “. One well-known example is the Hot Hand in basketball. A player who makes a few baskets in a row is considered to have a hot hand, which implied that he has a higher-than-normal chance of hitting the next shot. “ said Mauboussin.

According to him, we see patterns where none exist because we are wired to expect that the characteristics of chance show up not just in a total sequence but also in small parts of the sequence. Behavioural economist Amos Tversky and Daniel Kahneman call this “ belief in the law of small numbers.”

Mauboussin is quick to explain that the luck factor comes into play because making money is a hugely powerful motivator and thus draws in the smartest people in the world. This leads to competition at such a high level that differences in results are mostly luck, especially in the short-term.

image credit to

The author shares this graphic to illustrate where he views investing in “skill to luck “ factors in various activities. He further explains his insight and thought about "luck vs skill " in his book on the below interview :

What roles do skill and luck play in our successes and failures?

MM: I think about this as a continuum: at one end you have pure luck and no skill, and at the other end you have a pure skill and no luck. Examples of the first end of the continuum – pure luck, no skill – could be roulette wheels, lotteries or similar kinds of things. Pure skill, no luck might be running races or a chess match. Almost everything is arrayed somewhere in between. For example, sports like basketball are actually much closer to being all skill. Ice hockey is much closer to being all luck. Thinking about your decisions, the key is to know where your activity lies on that continuum.

How much does pure luck contribute to investment success?

MM: A lot of investment results – especially in the short-term – are based on luck, but maybe not for the reason that people believe. There is a lot of skill in markets and investors themselves are all very similarly skilful – this is reflected in prices. As a consequence, that leaves more to luck and is the reason why short-term outcomes can mostly be put down to luck. Having said that, any serious study of past investment performance demonstrates that differential skill does play a role. Some investors clearly have more skill than others. But, by and large, especially in the short-term, luck mostly dictates the results.  

How can investors put these insights into play when making investment decisions?

MM: The key for investors is to understand the kinds of mistakes they are likely to make. There is some interesting literature on heuristics and biases: this is the notion that we use rules of thumb that tend to give us the right answer most of the time, but they also lead to biases. So, you have to learn about those things. Secondly, it is important for investors to always distinguish between fundamentals and expectations. Asset prices, for example, stocks, reflect a set of expectations for the future. The key is to think about what fundamentals have to be in place for that to happen or to make sense. To sum up, it is really a combination of learning about the literature and then applying it successfully.

This video clip  on Google Talks by M Mauboussin has a further explanation on issues like :

- Reversion to mean
- Paradox or skill
- Understanding of Cognitive Biases 
- Contrarian vs Calculation in investing
- Why Mona Lisa which been painted in 1503 only became famous 300 years later?
- Can we improve or manage our luck?

In selling their fund from Bank or Insurance company will always show you the “winners” or the best fund,,, which most of the time also as a result or affected by “ Survivorship bias “ when the weakest already being eliminated.

But what about “ Warren Buffett “ ?  or other " super-investors ",,, just look at above probability, one requires 1 in 2.3 million to beat the market in 15 years, in Warren’s case, who has to outperform the market in over 40 years,, what will be the probability among the fund managers ?? may be close to 1 over 100 mils??

So, what do you think our skill can out-perform the market? else, we may opt for more passive ways of investing like “ ETF “. If we think we can try to beat the market with a lower % point than Warren Buffett,,, then by all means, please proceed with this challenge in picking your own stocks and portfolio.

Human being likes to have a challenging task ! by nature ….

Cheers !!

PS: Further Reading

A very good link about “ Luck vs Skill in Active Management Fund “ from famous Blogger and Author: Ben Carlson ( A Wealth of Common Sense ).

Quote Of The Day :

"The market does not run on chance or luck. Like the battlefield, it runs on probabilities and odds." by David Dreman


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