“Not everything that matters can be measured, and not everything that can be measured matters.” – Michael Mauboussin
Our clients and long-time readers of our Weekly Insights blog know that we are big proponents of taking a humble approach to investing. By that we mean that our goal is to try to spread risk across as many unique investment opportunities as possible rather than putting all our eggs in a couple baskets (e.g. stocks and bonds). We don’t try to predict the future and have a healthy respect for the market’s ability to make even the wisest of investors look like a fool on a regular basis. And there-in lies the rub. If even the best investors can be made to look like fools over the course of days, weeks, months, or even years because of all the various complexities of the global economy, how can we decipher what makes a skilled or just plain lucky investor?
This past weekend I picked up a new book entitled The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing by Michael Mauboussin. Now I’m only a chapter into the book, so I can’t give you my full review, but I can tell you that several sections have already jumped out at me as supremely important to the discipline of investing. In the first chapter, the author unpacks the definitions of luck and skill, and how everything in life falls somewhere on the “luck-skill continuum.” For example, a mathematically based game such as chess or checkers with clearly defined rules has very little if any luck involved and is almost entirely skill based. A highly skilled chess player such as Garry Kasparov or Bobby Fischer would beat a novice chess player 100% of the time. There is no amount of luck that could help a novice player against a world champion chess master.
On the other hand, a game such as the lottery or roulette is 100% luck based. There is no skill involved in picking a selection of random numbers or guessing a number for a ball to land upon. The easiest way to understand whether or not a game involves any skill or is purely luck based is to test whether or not someone can lose on purpose. If you can lose on purpose, then the game involves some amount of skill, but if you can’t, such as the lottery, then the game is entirely luck based.
But most things in life are a combination of skill and luck, including but not limited to business, sports, and investing as the title of the book would lead us to believe. It is in these activities in which the human brain has a very hard time coming to terms with the influence luck can have on a particular outcome. Our brain is wired to try to understand a cause for every effect, but a complex world doesn’t always work in this nice, linear fashion. I found the following quote from Michael Mauboussin’s book to be very informative on this subject (bold emphasis added).
It’s hard to discuss skill in a particular activity without recognizing the role of luck. Some activities allow little luck, such as running races and playing the violin or chess. In these cases, you acquire skill through deliberate practice of physical or cognitive tasks. Other activities incorporate a large dose of luck. Examples include poker and investing. In these cases, skill is best defined as a process of making decisions. So here’s the distinction between activities in which luck plays a small role and activities in which luck plays a large role: when luck has little influence, a good process will always have a good outcome. When a measure of luck is involved, a good process will have a good outcome but only over time. When skill exerts the greater influence, cause and effect are intimately connected. When luck exerts the greater influence, cause and effect are only loosely linked in the short run.
I found it interesting that the two examples Michael gave for endeavors that involve a good amount of luck are poker and investing, since I love both of those activities. The intermingling of skill and luck is why it is so hard to decipher good versus lucky or bad versus unlucky investors. The only way to really tell is look at a long-enough time period where skill eventually wins out over luck. But as the disclaimer goes, past performance is not indicative of future results. As such, the best judge of long-term success when it comes to investing is to judge the process rather than the short-term results.
Ben Carlson is probably our favorite fellow investment manager/blogger, and he also wrote on the importance of process in a complex world where luck and randomness can play huge roles. His opening paragraph was a perfect summary of his sentiments on the matter.
Thinking process over outcomes is one of those simple, yet difficult pieces of advice that is useful in many areas of your life. It’s difficult because we’re so obsessed keeping score and thinking in binary right or wrong terms. Since luck and randomness play such a large role in a complex world it’s more important to distinguish between good or bad decisions not being right or wrong every single time.
If the message of today’s post sounds familiar, it’s because we’ve written about it several times before. Back in early 2014 David wrote about Ray Dalio’s, largely considered the most successful hedge fund manager in the world, short-term performance struggles in What’s Luck Got to Do With It?. The reason we continue to pound this familiar drum is to help people understand the importance of sticking with a disciplined process when it comes to investing for the long-term. It doesn’t necessarily have to be the same process we believe in and follow, but it needs to be one that you will stick with through thick and thin. If not, then the cost of being human will derail any chance of success you may have at reaching financial independence. As stated in the opening quote, which is an adaptation of another quote attributed to Albert Einstein, just because something like short-term investment performance can be measured, doesn’t mean that it matters when it comes to deciphering the merit of the investment process.
Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.
Transparency is one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.