Thursday, January 24, 2013

Investment success: skill vs.luck

I recently finished Michael J. Mauboussin's newest book, The Success Factor: Untangling Skill and Luck in Business, Sports, and Investing, and strongly recommend it. He raises a great deal of interesting points, and I hope to interview him for The Journal of Performance Measurement(R).

He discusses the use of a luck/skill continuum, ranging from activities which are 100% luck (e.g., lotteries) to 100% skill. He points out that sports can be placed on this scale, where we will find that, for example, the results of basketball games are much more based on skill than baseball games.

Investing involves a certain amount of luck, too. We know that investors chase returns, and so can expect that the #1 mutual fund for 2012 will see an increase in assets under management shortly after the list is published. It's also likely that this fund may be relatively small, and perhaps with not a very long track record. This won't stop investors who (think they) "know a good thing when they see it."

Investor John Paulson received a tremendous amount of attention as the result of his phenomenal success in shortselling subprime mortgages. I questioned whether it was fair to reward him with such accolades, and was criticized by at least one fellow who revered Paulson's investment acumen. Clearly his amazing success in 2007 was worthy of attention. But how much luck factored in? Has he continued to have similar results? While I don't monitor his performance closely, it appears the results have been somewhat mixed. How much luck versus skill played a role is difficult to assess.

Sadly, measuring luck is difficult. As Mauboussin points out, when there is a fair degree of luck involved (e.g., in black jack), one can make good decisions (e.g., doubling down when the dealer shows a "6") and do poorly, or make bad decisions (doubling down when your cards total 12 (yes, I've seen this done) and (a) not "busting" and (b) winning the hand!).

How much do we want to talk about luck when it comes to investing? How much would we want to let our clients or prospects know about the degree that luck played in our investment successes? Imagine if performance attribution models were enhanced, so they could represent, for example:
  • Allocation effect
  • Selection effect
  • Interaction effect (I have to have this, especially for my friends Carl & Steve)
  • Good luck effect
  • Bad luck effect.
And what if most of the excess return came from "good luck." How would that go over?

No comments:

Post a Comment

Note: Only a member of this blog may post a comment.