Investing – Skill vs Luck

Imagine that you receive an email saying “Follow our system that guarantees to help you swim like Michael Phelps or run like Usain Bolt”. Most of us would have a hearty laugh and delete that email. Now imagine you receive an email that says “Follow our system that guarantees to help you invest like Warren Buffett”. Many of us would get interested and some of us will actually consider pursuing it.

Both emails are promising to transform our performance to resemble one of the best in the world. One we mostly delete and the other we may consider. Let’s examine the difference between the first and the second propositions.

We instinctively know that activities like swimming, running, playing chess, playing a piano are based on hard skills and it is very difficult to master them. We also intuitively know that playing roulette, blackjack, poker, investing have an element of luck involved and hence we believe that we can also succeed (get lucky). This is one of the reasons why there are a lot more people gambling at the casino as opposed to the number of people trying to be the best at swimming, running or playing chess.

Most activities in life lie somewhere in between the spectrum of pure skill and pure luck. Some may have more skill component and some may have more luck component.

skill-vs-luck

Pure skill based activities have objective feedback – number of seconds one takes to swim or run a lap. And the benchmark of the best performers is readily available and hence it is easy to figure out one’s standing. This objective feedback also helps someone who is serious to get better at the skill.

In pure luck based activities it is easy to take credit for the “success” and blame failure on bad luck. This makes it easy for one to feel optimistic and hence keep at the activity without doing much to improve one’s chance of getting a better outcome. This could explain the popularity of casinos, lotto’s and other events where luck plays a large role, where people are consistently losing money.

People who are trying to get better at skill based activities have it “relatively easy” – they have objective feedback. They can break up the activity into multiple components and try and work on each one of them to improve their overall performance.

People who want to pursue activities that have inherently a larger component of chance involved need to first understand that nature of their activities. That way they are not carried away by their successes or dejected by their failures. They also need to understand the probabilistic nature of the activity they are pursing and figure out odds for each approach. For instance there is a body of information out there about how blackjack should be played – when to hit, stand, double, split, surrender etc.  Players in the luck based games need to internalize the statistically optimal approaches and need to exercise the discipline to execute their strategies thorough an organized process. A structured approach can help improve their odds of winning.

Investing is one of the activities that is bit closer to the luck end of the skill-luck spectrum. Let’s look at the steps potential investors can take.

  • Investors need to have an overall philosophy that they believe in. For instance pure value investing, growth investing, contrarian bets, betting on black swan events etc. All these philosophies are distinct but also overlap at the boundaries. Each investor has to figure out the “philosophy mix” that makes most sense to her.
  • Once the overall philosophy is in place, then one needs to work out how to measure the odds for various scenarios and come up with an execution strategy. For instance value investor may want to look at historical P/E or P/B ratios at which investments have a good chance of giving satisfactory returns. Black swan investors need to have an approach to understand the current odds the market is factoring into various events and compare it with historical data to see if there is a discrepancy that can be profitably exploited.
  • Once execution strategy is in place, then they need to put a process together to be able to implement the strategy in a disciplined manner. It is also important to collect data about various outcomes and use that to update & refine the process.

One should remember that investing is not pure science as there is an element of chance involved. This is the reason that even the most successful investors have lost money on some of their transactions. Some of the failures are also due to lack of discipline in following their process.

There is a host of literature which helps understand and evolve successful strategies – “Superforecasting” by Philip Tetlock, “The Success Equation” by Mike Mauboussin, “Fooled by randomness”, “The black swan”, “Anti fragile” by Nassim Taleb, “Animal spirits”, “Irrational exuberance” by Robert Shiller etc.

I believe, understanding the probabilistic nature of investing, evolving robust strategies based on analytics, and having a well-defined process to implement the strategies will help investors generate a reasonable return on their effort and investment.

 

Happy investing …


 IndusWealth:Making your money work for you

About Praveen Reddy

http://in.linkedin.com/in/praveenreddyinduswealth

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