Friday, July 16, 2010

Michael Mauboussin: Untangling Skill and Luck

Found via Simoleon Sense.

For almost two centuries, Spain has hosted an enormously popular Christmas lottery. Based on payout, it is the biggest lottery in the world and nearly all Spaniards play. In the mid 1970s, a man sought a ticket with the last two digits ending in 48. He found a ticket, bought it, and then won the lottery. When asked why he was so intent on finding that number, he replied, “I dreamed of the number seven for seven straight nights. And 7 times 7 is 48.”

Outcomes from many activities—including sports, business, and investing—are the combination of skill and luck. Most people recognize that skill and luck play a role in results, yet they have a poor sense of the relative contribution of each. The ability to properly untangle skill and luck leads to much better thinking about most day-to-day outcomes, and allows for sharply improved decision making.

The process of asset allocation in the institutional investment industry is a practical example of the failure to conceptualize skill and luck. In the aggregate, institutional money tends to flow to assets that have done well and fails to consider sufficiently the role of luck. One recent study suggested that this misallocation of resources had cost these portfolios $170 billion from 1985 to 2006. The study’s authors conclude that those institutions “could have saved hundreds of billions of dollars in assets if they had simply stayed the course” instead of moving money based on a naive extrapolation of past results.

It’s important to define skill and luck before we get too far into the discussion. Skill is “the ability to use one’s knowledge effectively and readily in execution or performance.” You can think of skill as a process, or a series of actions to achieve a specific goal. Luck is “the events or circumstances that operate for or against an individual.” Luck, in this sense, is above and beyond skill. Consider luck as a distribution that has an average of zero. By this definition, luck tends to be transitory.