Pro Investment Picks: Skill or Luck?

How much does luck play in a fund manager's success? iDd takes a look.

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Transcript

Ever scroll through financial news, you know,
and see those headlines.
Like, this guy made a killing in the market again.
It's like, come on, how'd they do it, right?
Yeah.
Do some people just have this, like,
sixth sense for picking winners?
Well, today we're gonna try to unpack that,
this whole debate about skill versus luck in investing.
We're diving into this paper.
It's called, get this, skill and luck.
Straight forward.
Yeah, right.
No fancy jargon here, but don't let that fool ya.
This paper gets into some seriously juicy stuff.
It does.
How much control do we really have over our investments?
Because, let's be honest, sometimes it feels like
the market is basically just-
A casino.
Exactly, a casino.
Well, and that's actually how this paper kicks things off
with a pretty simple analogy.
Think about rolling a die, right?
Six sides, one in six chance of landing on any given side.
Pure chance.
Okay, yeah.
But even with those odds, everyone knows,
you're gonna get streaks, right?
Like, you could roll five sixes in a row,
and it doesn't mean you're suddenly an expert dice roller.
Right, just means you're on a roll.
So, are you saying that just because someone has
a couple good years in the market-
Doesn't necessarily mean they've got some magic touch.
It could be a lucky streak, absolutely.
Okay, so short-term success in the market.
Not the best indicator of actual skill.
Got it.
So, what does this research say does matter?
If we're really trying to figure out
who's got the real deal,
the investing equivalent of LeBron James
or Serena Williams?
They make the case for consistent long-term outperformance.
Think decades, not quarters.
Okay, so anyone can have a hot minute,
but to really prove skill,
you gotta be in it for the long game.
And speaking of long-term winners, or the lack thereof,
this paper brings up the SPIVA scorecard.
Which, for those who aren't familiar,
it's essentially a scorecard for mutual funds.
They track their performance over time.
Right.
And the spoiler alert here is that
very, very few funds manage to stay at the top
for very long.
It's true, the data's pretty clear on that.
Those consistent long-term outperformers,
yeah, they're about as common as...
Unicorns.
Pretty much.
Which begs the question,
if it were just about skill,
about picking the right stocks.
Shouldn't we see more of those superstar investors
staying on top?
What's the deal with this lack of consistency?
Well, the paper gets into some systemic issues
within the industry itself,
like conflicts of interest, for example.
Okay, so it's not just about individual investors
making bad calls.
There's more to it than that.
Right.
You've got things like, say, closet indexing.
Which is basically where a fund claims to be
actively picking winning stocks.
You know, doing all this research.
But in reality, they're just mirroring a market index.
So you're paying higher fees
for essentially the same performance.
So it's like, I'm picturing this gourmet restaurant, right,
with white tablecloths.
And then they serve you a microwave dinner.
Exactly, and you're paying a hefta price for it.
And then you've got revenue sharing agreements,
where some funds get kickbacks
for pushing certain investments,
even if they're not the best fit for the client.
Okay, yeah.
Not exactly putting the client's needs first.
No, definitely a conflict of interest there.
Sounds like the business side of investing
can sometimes...
Clash with the professional side, yeah.
Yeah, where it should be about
helping people reach their financial goals.
Exactly.
Right, right.
And that's not even getting into the fees
that eat into your returns.
Fees can be a huge drag on performance over time.
But let's say, hypothetically,
you manage to avoid those organizational pitfalls.
How much does luck
still play a role on an individual level?
Well, this paper tells a pretty wild story
about this guy, Michael Mauboussin.
He's a pretty big deal in the finance world.
I know the name, yeah.
And his career path is...
Well, let's just say it involves a very specific piece
of Washington Redskins merchandise.
Okay, no, I gotta hear this.
So, picture this.
Mauboussin, fresh out of college.
He lands a final round interview,
big time investment firm.
He's in the head honcho's office,
feeling the pressure, you know.
And he notices something a little out of place.
What, like a rubber chicken on the desk?
What is it?
Even better.
A Washington Redskins trash can.
Seriously?
Seriously.
Just sitting there.
Okay, most people would probably
try to ignore that, right?
Pretend it's not there.
Not Mauboussin.
He decides to comment on it.
Bold move.
Turns out the head honcho is a huge Redskins fan.
Oh, no way.
You can't make this stuff up.
Right, so they start talking football.
The interview goes way over time.
Mauboussin ends up getting the job.
I'm guessing the trash can talk sealed the deal.
Well, here's the kicker.
He finds out later that the other interviewers
actually voted against hiring him.
Whoa.
But the head honcho, the Redskins fan,
he overruled them.
That trash can, my friend,
launched this guy's entire career.
That is wild.
It really makes you wonder how many other
success stories out there hinge on these
totally random chance encounters.
Exactly, it really highlights the role of luck.
You can't predict it, you can't control it.
It just happens.
Okay, so if luck can be such a big factor,
how do we even begin to separate those lucky breaks
from actual replicable skill?
How do we even define those things?
Right, well, the paper defines skill
pretty much how you'd expect, right?
It's about applying knowledge effectively
to get the results you want.
Okay, so you know your stuff
and you're consistently successful because of it.
That makes sense.
What about luck, though, how they define that?
They give three main criteria.
One, it has to affect someone
either positively or negatively.
Two, the outcome has to be uncertain beforehand.
And three, a different outcome
could have reasonably happened.
So it's not just about the outcome itself,
but the possibility of other outcomes.
Okay, so there's always this element of what if.
What if things had gone a different way?
What if Mobusan had just ignored that Redskins trash can?
Exactly.
Okay, that's helpful.
But how do we know if something involves any skill at all?
Like, is there a test for that?
Some kind of skill detector?
There is.
The author of this paper,
he proposes a really interesting test.
He says, if you can lose on purpose,
then there's skill involved.
Okay, I think I'm following.
Like, think about a game of chess, right?
You can intentionally make bad moves.
Throw the game if you want to.
You could do the same thing in basketball, right?
You could try to miss a shot.
Okay, sure.
But can you intentionally make bad investments?
Can you just decide to lose money in the stock market?
That's a good point.
No, you can't, at least not easily,
not without like insider trading
or something illegal like that.
Exactly, which suggests that investing,
even when you're doing everything right,
There's still this element of luck involved.
Right, you can make smart decisions,
do your research, but you can't control everything.
Okay, that's a mind-blowing way to think about it.
So how do we wrap our heads
around this whole interplay of skill and luck?
If we can't control it all, what can we do?
Well, the paper lays out three main lessons,
things to keep in mind if you want to be successful,
not just in investing, but really in any field.
And the first one is that outliers,
those truly exceptional cases.
Like the Warren Buffetts of the world.
Right, exactly.
They're usually a combination of both skill and luck.
Think of it like a golfer sinking a hole in one.
Okay, I'm picturing it.
What, did they bounce it off a tree?
Maybe, the point is they needed the skill
to hit the ball in the first place,
but luck played a huge role in that outcome.
So even the pros get a little lucky sometimes.
It happens, and it's the same in investing.
Those investors who are consistently beating the market,
are they good?
Sure, probably, but did they also get
that lucky bounce at a critical moment?
So lesson number one,
outside success is rarely one or the other.
It's usually a bit of both.
Okay, what's the second lesson?
What else do we need to keep in mind?
The second lesson is the idea of reversion to the mean,
which basically means that things
tend to even out over time.
Okay, so what goes up must come down?
Sort of.
Imagine a family where the father is incredibly tall,
like head and shoulders above everyone else.
Okay, yeah.
Chances are his son is also gonna be tall.
Sure, makes sense, genetics and all that.
But the son is probably gonna be closer to average height,
not as exceptionally tall as his father.
So it's like gravity is pulling those extreme results
back towards the middle.
Exactly, and this applies to investing too.
You see these periods of exceptional performance,
either with a single stock or a whole portfolio.
And then boom, things go back to normal.
More or less, same goes for the opposite.
A really bad year is often followed by a more typical one.
It's that whole what goes up must come down idea,
but also what goes down.
Must come up.
Exactly, except hopefully not too dramatically
when it comes to our investments.
Right, okay, so we've covered outliers
and reversion to the mean.
What's that third lesson that really stands out?
This one's a bit of a head scratcher.
It's the idea of the paradox of skill.
Basically, it says that as everyone in a field gets better,
like in professional investing, for example,
the difference between the best
and the average actually shrinks.
Wait, so if everyone's upping their game,
shouldn't the best just keep pulling further ahead?
What's paradoxical about that?
You'd think so, right?
Yeah.
But the paradox is that as the overall skill level rises,
luck becomes a bigger factor in who comes out on top.
Okay, now my brain is officially a pretzel.
Give me an example.
How does this whole paradox thing
actually play out in real life?
Think about the Olympic marathon.
If you look at the winning times over the decades.
They're way faster now than they used to be.
Athletes are stronger.
Training methods have improved.
The whole field has leveled up.
Those marathon runners are practically superhuman.
Absolutely.
But here's the paradox.
Even though the overall times are faster,
the actual difference in finish times
between the gold medalist and say the 20th place runner,
that difference has shrunk dramatically.
So even though everyone's gotten faster,
the competition at the very top is even tighter.
Exactly.
It comes down to these tiny margins of error
where a slight stumble or a burst of energy
at just the right moment
can completely change the outcome.
So as everyone gets better,
it's those tiny margins where luck operates
that become even more important.
Exactly.
It's like that old saying,
in the land of the blind, the one-eyed man is king.
But if everyone suddenly has decent vision,
that one-eyed advantage
doesn't really mean as much anymore.
Okay, now I see why they call it a paradox.
It's counterintuitive,
but it makes sense when you really think about it.
This is reminding me,
we've been talking a lot about results,
who's winning, who's losing,
but the paper also stresses
that having a sound investment process
is just as critical as those outcomes.
Couldn't agree more.
And it's especially true over the long run.
Totally.
So what does a solid investment process look like?
Well, the research breaks it down into three key components,
analytical, behavioral, and organizational.
Okay, so it's not just about picking the right stocks,
it's bigger than that.
Right, you gotta have the right mindset,
the right systems in place.
So let's break it down starting with the analytical side.
What does that entail?
The analytical part is all about finding
what they call an investment edge.
An edge, what do they mean by that?
Basically, it's about understanding the difference
between a stock's price and its intrinsic value.
So what the market says it's worth
versus what it's really worth.
Right, and there's this great quote in the paper
from a, get this, horse racing handicapper
that really captures this idea.
Okay, I'm not much of a gambler, but I'm listening.
So this handicapper, Steven Kreist, he said,
and I quote, the issue is not which horse in the race
is the most likely winner,
but which horse or horses are offering odds
that exceed their actual chances of victory.
So it's not about betting
on the absolute best horse every time.
Exactly.
It's about finding the ones that are undervalued,
the ones with more potential upside
than the market is giving them credit for.
Precisely, you replace horse with stock,
and you've got yourself some solid investment advice.
It's about spotting those diamonds in the ref,
those hidden opportunities
that everyone else is overlooking.
Love that analogy.
Okay, so analytical thinking is all about finding that edge,
doing your homework, understanding the fundamentals,
but it's not just about crunching numbers, is it?
There's a human element to this too, right?
Absolutely, and that's where the behavioral side
of investing comes in, because we're all human
and we all have our biases, right?
Oh, for sure.
We let our emotions get the best of us sometimes.
It happens, and this paper highlights the importance
of balancing two perspectives,
the inside view and the outside view.
Okay, I'm intrigued.
What's the difference?
So the inside view is all about those specific details.
You're gathering information, analyzing the nuances,
really getting into the weeds of a particular investment.
Okay, so it's that laser focus,
really understanding the ins and outs
of a specific company or industry.
What about the outside view?
The outside view takes a step back
and asks, what typically happens in situations like this?
It's about looking at historical data,
considering base rates.
So understanding the bigger picture,
the patterns that emerge over time.
Precisely, and the paper argues that we often get
too caught up in the inside view.
We become so focused on the details,
the stories we tell ourselves,
that we miss the bigger picture.
We convince ourselves that this time it's different,
even when all the data suggests otherwise.
Exactly, like, let's say you're thinking about investing
in a hot new industry.
You might get caught up in the excitement, right?
The hype, the charismatic CEO, the innovative products.
But we can't let that excitement
completely cloud our judgment.
Exactly.
We need to balance that inside view,
the compelling narrative with the outside view,
asking ourselves, what's the track record
for companies in this industry?
What does the data tell us?
Right, it's about marrying that narrative
with the statistical reality.
Exactly, it's about acknowledging that
while every situation is unique,
there are these recurring patterns and trends
that we can learn from.
Okay, so much to think about.
We've covered the analytical side, the behavioral side.
Anything else we should keep in mind
when it comes to making smart investment decisions?
There is, we haven't talked much
about the whole organizational side of investing.
You know, we touched on it earlier
with those conflicts of interest.
Right, right, how the business of investing
isn't always aligned with.
With actually being good at investing.
Like, sometimes it feels like they'd rather just sell you
on something flashy than-
Than actually help you reach your goals.
Exactly, so how do we as individual investors,
how do we protect ourselves from those bad actors?
What are some red flags to watch out for?
Well, one thing to be wary of is this constant churn
of complex financial products.
When a firm seems more interested
in launching the next big thing
than in sticking to its core investment philosophy.
It's all about chasing those fees.
A lot of times, yeah.
And that's not always in the client's best interest.
Okay, so constant innovation isn't always a good thing.
Not necessarily.
Another red flag is a lack of transparency.
You know, if a firm is being cagey about its fees
or its track record-
Yeah, that's never a good sign.
It's your money.
You have a right to know what's going on.
Transparency is crucial, for sure.
Okay, what else should we be on the lookout for?
Watch out for firms that seem to prioritize
marketing and sales over actual research and analysis.
So if they spend more time trying to woo new clients
than they do actually managing the money.
That's a red flag.
Because at the end of the day,
it doesn't matter how slick their marketing is.
Right.
If their investment process is flawed.
You're not gonna get the results you want.
Okay, that's some solid advice.
So we gotta be savvy consumers, do our due diligence,
make sure we're not getting played.
Exactly, it's your financial wellbeing on the line.
All right, so we've covered a lot of ground here.
We talked about skill, luck,
the importance of a sound investment process.
Oh, this has been a whirlwind.
But there's one more concept from the paper
that I wanna make sure we touch on before we wrap things up.
This idea of price implied expectations.
Ah, yes, it's a good one.
It sounds kind of intimidating,
but I have a feeling it's a really important concept
to grasp.
It is, basically it's the idea that a company's stock price
at any given moment reflects.
Well, it reflects the collective expectations
of all investors.
So it's not just about a company's current earnings
or its assets?
Not just that, no.
It's also about what the market anticipates
will happen in the future.
So it's like the market is trying to predict the future,
which is kind of impossible, right?
Yeah, no one has a crystal ball.
But the market is always trying to anticipate
what's gonna happen next.
And by digging into a company's stock price,
we can actually try to reverse engineer
those embedded expectations.
Okay, that's fascinating.
So how does that work in practice?
Give me an example.
Let's say you see a company that's trading
at a really high price-to-earnings ratio.
P-E ratio.
Exactly, and that P-E ratio is way higher
than say its historical average
or the average for its industry.
So the market is expecting big things from this company.
Right, that high valuation,
it suggests that the market is anticipating
significant earnings growth in the future.
So there's pressure on that company to deliver.
Absolutely, because if their earnings fall short
of those lofty expectations.
Uh-oh, stock price takes a hit.
Very likely, and that's why understanding
price-implied expectations can be so powerful.
Okay, so it's like a reality check.
You can use it to see if a company's current valuation,
if it's actually justified, or if-
Or if it's all hype.
Exactly, all hype.
This is blowing my mind.
It's not just about reading financial statements.
It's about understanding market sentiment,
what other investors are thinking and expecting.
Precisely, it's a more nuanced approach to valuation.
It's not just about crunching numbers.
It's about trying to understand the collective psychology
of the market, which, let's be honest,
can be pretty irrational sometimes.
Oh yeah, for sure.
The market can be a fickle beast.
Well, this has been an incredible conversation.
So many things to think about.
I feel like we've only just scratched the surface
of this whole skill versus luck debate.
We really have, but hopefully this gives our listeners
a good starting point.
Definitely, and a huge thank you to our expert for,
well, for being our guide on this journey.
It's been enlightening, to say the least.
My pleasure, always happy to talk about this stuff.
And to all of our listeners, thanks for tuning in.
We'll be back next time with another deep dive
into a topic that's sure to make you think.
Until then, happy investing.