The Role of Luck and Skill in Your Portfolio

Julian Koski, Co-Founder and Chief Investment Officer, New Age Alpha
Mar 12, 2020 1:12:24 PM 5 min read

Despite the ubiquitous disclaimers, most investors are fully aware that past performance is no guarantee of future results. Nevertheless, they chase the past performance of investment managers. Investors hope that past performance is at least an indication of skill, and that last year’s best performer will be next year’s best performer. They are left to speculate whether the investment manager in question skilled or just lucky. It is an important distinction, as skill has implications for our expectation of the future, whereas luck does not. But assigning causality to an outcome is always difficult, and a system that involves even a small amount of chance can make it hard to isolate skill but investors try to do so anyway. 

 

Luck vs. Skill and Human Nature 

This misunderstanding of luck and skill is not limited to investments. The human brain is in constant search of patterns, causing it to interpret a lucky series of events as a pattern that can be expected to continueThis inclination is so strong that we sometimes see patterns even when they don’t exist. Psychologists call this apophenia, while statisticians call it a Type I error. The challenge is in overcoming this tendency. Often, quantitative analysis is a solution.  

Consider the developments in sports strategy such as baseball’s sabermetrics. Teams implementing these approaches know that winning is the result of what you can control, skill, as well as what you cannot, luck, and they recognize that erroneously seeing a pattern by way of human judgement is a recipe for failure. They also understand that by discerning the lucky and skillful qualities of a player they can design a better team.  

 

The Luck vs. Skill Continuum  

The recognition of the contribution of luck to outcomes is important, as it enables us to think along a luck-skill continuum that describes the contributions of each to results. For instance, playing the piano takes almost no luck. To become a better pianist, one must practice, learn and develop skill. Because piano ability is subject to very little luck, experts are immediately distinguishable from novices. Experts are also relatively rare, and often can support themselves as professionals. 

In contrast, there are no professional coin flippers. The way a coin lands is a random event and if a coin flipper is successful at correctly calling how the coin lands, he is simply lucky. Evidence of this can be found by asking the coin flipper to lose. He cannot intentionally lose no more than he can intentionally win. He may be successful around 50% of the time in small samples, but as he flips more and more his success rate will approach 50%. 

So where are investment managers on this luck-skill continuum? It is hard to say exactly, but certainly somewhere in the middle. It’s important for investors to not be fooled by streaks or reversals in activities guided by luck. Yet many investors blindly choose the investment manager with the best track record because they attribute all of that success to skill. And remember, when it comes to the stock market you cannot deliberately lose which, in and of itself, suggests that there is much more luck involved in picking stocks than skill. 

 

Is Your Investment Manager Skilled or Plain Old Lucky? 

Legg Mason’s Bill Miller became famous in the 1990s and 2000s for beating the S&P 500 for 15 consecutive years. Statistically speaking, this is highly unlikely to be the result of luck alone, so it is understandable that one might conclude he is skilled. Yet even that legendary streak came to an end eventually, and after a disastrous 2008 in which his flagship fund lost 58%, Miller was no longer looking like the skilled manager he was once assumed to be. Whereas good luck might have contributed to his success, bad luck might have contributed to his failure. Regardless, both skill and luck played a role. 

Ironically, investment managers themselves seem to understand this best - look no further than how they construct portfolios. Realizing the role of luck in determining success, managers diversify their portfolios to achieve the greatest chance that they get lucky with as many investments as possible. This does not imply that the managers have no skill, but rather that they are concerned with luck obscuring their skill. 

When most investors think of the skills that they want their investment manager to have they likely think about an aptitude for stock picking that is the result of doing in-depth fundamental research coupled with the ability to accurately and reliably estimate company value. They may also assume the investment manager is unusually good at anticipating competitive forces in the marketEither way, the ability to do these sorts of things well is certainly a skill, but it is rare.  

A more common and simpler form of skill is the ability to avoid big mistakes. One way this skill manifests itself is through emotional discipline, because mistakes often happen when investors become emotionally involved in their investments. This is human nature, but the ability to prevent oneself from this influence will allow the investor to avoid buying at the top when optimism is peaking, for example. 

Human interpretation of vague and ambiguous information about a company can impound biases such as optimism - into the price of the stock. This may make the stock price too high or. In the case of pessimism, stock prices may fall too low. To most observers, buying the underpriced stock will be a matter of luck as they cannot differentiate between stocks with prices affected by bias and those without. 

Mastering the skill of controlling one’s own biases while identifying instances when biases have affected stock prices is a big contributor to investment skill, if for no other reason that it allows for the avoidance of bad luck. 

CC: NAA10029

 

Julian
Kern
Co-Written by Julian Koski, Co-Founder and Chief Investment Officer and Andy Kern, Senior Portfolio Manager