Is It Luck or Skill?

I admit that question is a bit arrogant, but it's one I ask myself all the time.

I've been fortunate that my investments have done well, and I'd like to attribute that to my skill as an investor. But at the same time, I understand that generating high returns isn't purely a question of skill; it requires some luck, too. So when I had the chance to speak with Michael Mauboussin, chief investment strategist at Legg Mason (NYSE: LM  ) and author of More Than You Know, I asked him about skill and luck in investing.

Excerpt from the interview
David Meier:
Your colleague, Legg Mason fund manager Bill Miller, is well known for beating the S&P 500 index for 15 years in a row. In your book you note that streaks happen to the most skillful in the field because their chance of success is higher than average. So, how much of Bill's 15-year streak do you think can be attributed to skill, and how much can be attributed to luck?

Michael Mauboussin: I think that is almost an impossible question to answer, but I think the point is absolutely right. Stephen J. Gould said, "Long streaks are, and must be, a matter of extraordinary luck imposed on great skills."

I think the key point, which you drew out and I discuss in the book, is the recognition that in almost any domain you go to, with professional sports being an excellent place to look for this, streaks are held by those people that are the most skillful. The reason for this is very straightforward, right? One example used in the book is two basketball players. One makes 60% of his shots, and the other makes 30% of his shots. The probability that the high-percentage shooter will have a streak is vastly higher than the low percentage shooter. Hence, the players with more skill are going to have the streaks.

By the way, if you look at Bill's streak, it happens to be a December-to-December streak. If you took any other ending month, January-to-January, February-to-February, etc, you would not see the same 15-year streak. So Bill's streak is to some degree a function of the calendar, and I think that is always worth bearing in mind.

To me, one of the most intriguing questions in investing is, "Is a manager skillful or not?" And I think the streaks, not only in the world of investing but in sports and other areas, may be one of the most powerful ways of identifying that skill.

So which is it?
Excerpt over -- now let's return to the question I often ask myself: Was my success due to luck or skill? Here's how I would answer.

I've been fortunate to outperform the S&P 500 since 1997. I haven't beaten the index every year, but I'm way ahead on average. Merchant energy company AES (NYSE: AES  ) has been my best-performing investment by far, and I believe it did take skill to recognize that the company was selling at a ridiculous discount in 2002. It also took some skill, along with a whole lot of courage, to buy AES shares at $4, at $2.50, and then finally to sell all of my shares of Steak n Shake (NYSE: SNS  ) and some of my shares of Nike (NYSE: NKE  ) , and invest all of that available cash in AES at $1 per share.

But I realize that luck has also played a role in how quickly the company's stock price has risen since. I never expected it to get to $18 as quickly as it did. Maybe that's what Gould means when he talks about luck imposed on skill.

Time plays a factor
It's important to measure the success of decisions over the proper time period. In his book, Mauboussin references a very interesting article by William Bernstein that in turn goes through a simple yet insightful analysis by Nassim Taleb. Basically, it shows that it's difficult to determine whether returns generated in less than a year's time are due to skill or luck.

The article appears to say that it's dangerous to evaluate investing decisions using short time periods -- it risks attributing success to skill, when it could very well be luck. This can lead to overconfidence, causing us to take on more risk than necessary, and leaving our portfolio vulnerable to an unexpected failure.

As I said, I invested in AES in 2002. Using a four-year time period, I am more confident that skill played a larger role than luck in the investment's outperformance.

Use it from the start
So far, I've talked about asking this question to evaluate a decision that has already been made. But it also might be useful to ask this question before making a decision. In this instance, you'd ask yourself how much luck will be needed to generate superior returns.

Since I don't want to rely on luck, I've stayed away from stocks like Google (Nasdaq: GOOG  ) and Hansen Natural (Nasdaq: HANS  ) , despite their popularity and fantastic returns, because of the lofty expectations built into their current valuations. What's more, I am aware that I don't have any special insights leading me to believe these companies can exceed these expectations. Thus, I am willing to pass, no matter how much higher the market takes these stocks.

If you can't be lucky, be good
I don't want any part of my portfolio to blow up. That's why I think it's important to understand the role of luck and skill in investing, and why I wanted to share Michael Mauboussin's thoughts on the subject. We don't want your portfolios to blow up, either. Instead, we want you to be better investors.

There's more great stuff from my interview with Michael on the way. But if you can't wait, I encourage you to read More Than You Know. Sorry, it's got no stock tips or get-rich-quick ideas. But I guarantee that this book will make you a better investor.

For more Foolishness with Mauboussin, check out:

This article was originally published on July 7, 2006.

Retail editor and Inside Value team member David Meier owns shares of Nike and AES but does not own shares in any of the other companies mentioned. He is ranked 619 out of 20,943 investors in the Motley Fool CAPS rating service. You can view his TMF profile here. Legg Mason is an Inside Value recommendation. The Fool takes its disclosure policy very seriously.


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