Skill versus Luck in Investing

Written by multiforte on . Posted in News

Last Sunday afternoon. Our son’s U17s AFL team is playing the Grand Final – the first ever for the team. And they’re the underdogs – facing the team who has been top of the ladder pretty much all season.

The two teams are well-matched. It’s the fourth and final quarter and the difference in score has only once gone beyond single-digits. There’s a minute to go, and the opposition is four points in the lead – just four points.

Fifteen seconds out. A clever pass, a swift kick, and it’s a goal. Our team did it. They won the grand final. In the last 10 seconds of the game. By two points.

Was it skill or luck that delivered the team the premiership? Maybe our team will argue that it was all skill – and the opposition, that it was pure luck!

The reality is, when you look at most activities, whether it’s sports or investing, both skill and luck are contributing.

Yet, like some sports teams, there are many investment managers out there who will claim that they are sufficiently skillful to consistently beat the market, and maybe just a few with the performance numbers to prove it.

Even with the top performing investment managers, we should still ask: are they truly skillful or did they just get lucky?

It’s very hard to know for sure.

Without doubt, there are some very skilled investment manager out there.

Michael Mauboussin, Head of Global Financial Strategies at Credit Suisse, and author of “The Success Equation: Untangling Skill and Luck in Business, Sports and Investing”, states there is a lot of skill in markets and investors themselves can be very skillful.

He applies a very simple test to distinguish skill from luck. He writes:

“There’s a quick and easy way to test whether an activity involves skill; ask whether you can lose on purpose. In games of skill, it’s clear that you can lose intentionally but when playing roulette or the lottery you can’t lose on purpose”.

He goes on to state that in investing, if it was 100 per cent about skill, that an investment manager could equally design a portfolio to outperform that market, as one that would deliberately under perform the market. He argues that either is exceptionally hard to do.

Recent research from Stanford Business School offers a slightly different view. The research suggests that the typical mutual fund manager is persistently skilled, and that top performers are especially good and can outperform markets.

The problem the researchers conclude, is that most investors don’t reap the benefits.

“It’s just that the market is so hyper-competitive that most investors can’t benefit from the skill — it is competed away too quickly… The managers and their companies, rather than investors, capture the value of the total market earnings and fees charged to investors”.

The paradox of skill is that the investment manager’s success is the very same reason that they end up delivering insufficient out performance to benefit individual investors.

You see, when a new investment manager with persistent out performance emerges, the market responds very quickly. Investors flock to invest in the fund, delivering more assets to invest. However, once a fund has a large asset pool to invest, the manager typically finds it harder to make money – as just one example, the manager now has to find enough attractive opportunities in which to invest a much larger amount of money.  Further, any residual out performance is whittled away in fees.

Little wonder then that Michael Mauboussin believes that, when it comes to investing, especially in the short-term, luck mostly dictates the results.  If you want to avoid luck driving your investment performance, he concludes that you need a clear and disciplined investing policy and process.

This is why our approach to investing is not about chasing trends in investment management or trying to forecast markets. And why we have a clear investment policy statement focused on a disciplined approach to securing the returns that the market has on offer.

Whether it’s investing or our son’s AFL U17s grand final, we’re happy when Lady Luck comes our way. But our fundamental game plan will be one of maintaining discipline and leveraging skill.


Insights by Stanford Business, 9 July 2014 “Jonathan Berk: Are Mutual Fund Managers Skilled, Or Just Lucky?”
The Economist 14 December 2012 “Distinguishing Skill from Luck”
ValueWalk June 4, 2015 “Michael Mauboussin: How To Determine If Your Investment Performance Is Driven By Skill Or Luck”