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Investing: Is It A Game Of Skill Or Luck?

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This article was contributed to us by endowus.

“I think it may be true that fortune is the ruler of half our actions, but that she allows the other half or a little less to be governed by us.” 
- Niccolo Machiavelli in The Prince

On June 3, 2017, Alex Honnold scaled El Capitan free solo without a rope: he climbed a 3,000-foot vertical granite wall with his bare hands and some chalk, in what is probably the most impressive feat in sporting history. 3 hours and 56 minutes of sheer concentration, strength and most importantly, skill.

Buying Tencent a year ago at $354, and watching it go up 34% in 3 months to $474, then crash 40% to $282 – that can be attributed to good luck followed by bad luck.

The influence of luck on outcomes has been understood for a long time. Despite having every manipulative trick up his sleeve, political mastermind Niccolo Machiavelli acknowledged the role that luck played in successful outcomes in his handbook for future rulers.

Five centuries later, Michael Mauboussin wrote about the difficulty of distinguishing luck from skill in business, sports and investing in The Success Equation. He shows how different activities sit on the scale of luck and skill: Chess sits on the far right of the chart (pure skill), and slots machines sit on the far left of the chart (pure luck). Where does investing fall on this scale?

Nobel Laureate Eugene Fama and Ken French published a paper “Luck versus skill”, where they analysed the performance of over 3,000 US mutual funds from 1984-2006 through the lens of their Fama-French 3 factor model (i.e. adjusted the performance for the excess risk that the funds took).

They discovered that in aggregate, the entire active fund universe underperformed the market by about the fees they charged their investors.

Naturally, some funds outperformed and some funds underperformed. How much of that outperformance was due to skill and not luck? Professors Fama and French determined that only the top 3% of mutual funds outperformed consistently net of fees. But the number that did outperform the market with a high degree of certainty was less than what is expected by random chance. (Source: IFA)

Mauboussin believed that the reason why luck is so important in investing is not that investors are not skilful – it’s actually the opposite.

Imagine if AlphaGo, Google DeepMind’s champion-beating computer program, played against itself. The winner of each game would be more dependent on luck, as skill would be the same. This is an extreme example, but the same applies to investing.

Investors are smarter, more skilled, and have access to more information today. Collectively they have become more efficient at incorporating information into stock prices. As a result, the outcome becomes more uniform with less dispersion of good and bad outcomes. Mauboussin calls this the paradox of skill.

As skill improves, as the average skill level improves, it actually increases the dependence of luck in determining results. Perhaps recognising the importance of luck in investing (and life) is a skill in itself. (Source: CNBC)

The more dependent an outcome is on luck, the more important it is to focus on the process. If you rely solely on luck, you may get to a good (or poor) outcome with some random probability.

A good process will give you the highest probability of achieving successful outcomes over the long-term. If markets have taught us anything – it is to be humble and admit that we are not all “above average”, and we do not know what the future holds. Instead of gambling our hard-earning savings and relying on luck, we would rather invest with and stay committed to an evidence-based disciplined process.

endowus is a MAS-licensed financial advisor that leverages technology to make investing accessible to all. If you enjoyed reading this article from The Know, you can subscribe to our weekly memo. Follow us on LinkedIn or connect with us on Facebook as we bring you financial insights from endowus.

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