Beating the Market: Investment Skill, or Luck?

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One of the eternal questions in investing is whether performance results are due to skill or luck. We’ll probably never get a universally-accepted answer, but Michael Mauboussin (chief investment strategist at Legg Mason Capital Management) explores the subject in his new book The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing.

I haven’t read the book, but in a WSJ interview the author shares a graphic illustrating where he views investing on the skill-to-luck continuum. At the extremes are the pure luck of roulette and the overwhelming dominance of skill in chess.

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.

This reminds me of another famous skill vs. luck argument by Warren Buffett called The Superinvestors of Graham-and-Doddsville (Wikipedia). You can feel his annoyance at the academics suggesting that his mentors were simply statistical anomalies.

For the record, I don’t believe in the academic definition of the efficient market hypothesis either. But as the graphic above suggests, market efficiency is not a yes/no situation but a matter of degree. Even Buffett has repeatedly stated that most investors would be better off in low cost index funds, and even wagered $1 million that the Vanguard S&P 500 index fund would outperform a basket of hedge funds over a decade. The bet started in 2008, and as of March 2012 the index fund is ahead. Of course, no matter who wins, was it skill… or luck?

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  1. Nice post.

    Note that there are actually three forms of the EMH: weak, semi-strong, and strong. Only the weak form is accepted by virtually all academics. Few academics believe in the strong form or that the market is always semi-strong form efficient.

    As an individual private investor, it makes little practical difference to me, given the current state of things, whether the semi-strong or strong forms are true or false. The discovery that they’re false wouldn’t wouldn’t cause me to opt for active management over passive indexing, since it’s still impossible to know in advance whether one has accurately identified a method, system, or manager which is genuinely able to exploit the market’s inefficiency on a continual, long-term basis.

    Think about it this way: Even if we *knew* that the EMH is false (which we don’t), all that would tell us is that there exists an “answer,” but it wouldn’t tell us anything at all about what that answer looks like. That’s not enough information to “solve” the “problem” of beating the market.

  2. Kurt @ Money Counselor says

    That the graphic locates investing in the same vicinity of other forms of luck-based gambling says it all I think! The extremely rare individuals like Peter Lynch and Warren Buffet aside, no “professional” money manager can consistently beat the indexes, or a dart-throwing chimpanzee for that matter! 🙂

  3. Jay @ effumoney says

    For the average investor luck is clearly part of the equation probably more so than skill, on the other hand for the professional trader skill is far more important than luck. Most people make the mistake of using the terms investing and trading interchangeably, they are not. If you are the average person investing and do better than others or the market you probably just got lucky, if you are a professional trader you have a much wider set of tools and knowledge available to you, the most important is knowing when to take a loss, which most investors never understand. This is not saying that traders cannot be lucky or that luck has nothing to do with their returns, but a bigger part of their returns are due to skill and not luck.

    Now I know the general response people will have is actively managed mutual funds or ETF’s or stock pickers are far less likely to beat the market then index funds, and I agree completely, but once again the goal of these funds is investing not trading, trading is about turning a profit and moving on, investing is about long term growth and investment income.

  4. I can’t help be distracted by the sports shown in that luck/skill graphic. I wonder how they come to the conclusion that football is a higher luck sport than the others? I assume thats a hockey puck shown as the least luck? Why so??

    I don’t imagine anyone here knows why… but I’m curious. Seems to me any sport has skill and some luck thrown in randomly. I mean ‘how the ball bounces’ is I guess the ‘luck’ element. But I don’t see how hockey is more ‘luck’ oriented than soccer or baseball.

    I can certainly see how chess is no luck.

    I also see how basketball would be less luck since you have so many baskets taken and the points are so high that it reduces the impact of luck in general. With >50 baskets shot in a game its not like a single basket will have much impact unless the game is real close. But with football its a lot easier for a random gust of wind to ruin a field goal which is more likely to impact the outcome of a game due to lower scoring.
    But hows there more luck in hockey than soccer? They seem pretty similar to me in general.

  5. Jim

    I think football is on the lower end of skill based on the number of iterations within a scoring drive. Two teams could have the exact same yardage gained for various plays (say +3, +8 +2 -2 +7 +4… etc.) due to first downs every 10 yards (a rather arbitrary amount) depedning on what order those plays occur in they could result in a touchdown, field goal, or a punt. The order of the plays is largely determined by luck.

    I do not have a guess as to why hocky is lowest of the sports.

  6. Carlos @ Financial Tales says

    Michael was on CNBC this morning and I had no idea he was promoting a new book, which is great considering the last thing I read of his was: Revisiting Market Efficiency: The Stock Market As A Complex Adaptive System. Journal of Applied Corporate Finance. I was hoping he would discuss complexity a little more, so I’m pretty excited to read his new book, though I am concerned that it may be mainstream garbage. I guess we’ll find out.

  7. Excellent blog post. I too wondered about hockey’s luck status (maybe it’s “luck” that the NHL even plays a season, har har har…) but also the two icons on the far left. Why are slot machines slightly more skillful and less luck-based than roulette? I would have thought they’d be dead even.

  8. Wired magazine has another interview with the author that provides more insight:

  9. Hey all,

    Thought it would be cool to come in and give my 2 cents.

    I read this probably from a different perspective from a lot of you guys (a sports bettors view) and the data is really really useful. It’s interesting to note that sportsbooks actually semi-ignore this type of data too. Which is why you still see NHL lines at -250 when they should realistically never go above -180 regardless of which 2 teams are playing one another.

    Just wanted to drop in as researching this for a blog post and saw some cool comments. Also emailed you Jonathan if you read this :).


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