Do lucky traders perform better than “normal” traders over time? And does pure chance deserve any place in your portfolio? Legg Mason Capital Management’s chief investment strategist, Michael J. Mauboussin, has a fascinating new PDF file floating around the finance world in forwarded emails.The 40-page piece is called “Untangling Skill and Luck: How to Think About Outcomes—Past, Present, and Future,” and one of our other writers has already covered a bit of it.
Mauboussin’s investigation into Lady Luck, however, deserves much closer attention.
“The outcomes for most activities combine skill and luck,” he writes at the outset. “Separating skill and luck encourages better thinking about outcomes and allows for sharply improved decision making.”
His litmus test for whether an activity is skill-based or luck-based is surprisingly simple: Can I intentionally lose at this activity?
“If you can’t lose on purpose, or if it’s really hard, luck likely dominates that activity. If it’s easy to lose on purpose, skill is more important,” Mauboussin explains.
Example of a luck-based activity: the roulette table, or the state lottery. You could pick numbers you believe won’t come in, but your odds would be exactly the same as playing your “lucky” numbers.
Example of a skill-based activity: chess. It is very easy to lose at chess on purpose.
The degree of luck or chance built into an event helps you understand how long you have until reversion to the mean occurs—in other words, you can intuitively figure out, perhaps, how much longer you can beat the system.
“Your initial reaction may be that more luck means less predictable outcomes—which is true. But there is also an important insight that follows from knowing the relative contribution of skill and luck: the ratio of skill to luck shapes the rate of reversion to the mean. Specifically, the outcomes of activities laden with luck revert to the mean faster than activities with little luck. Reversion to the mean is present in all activities that have even a dash of luck, but the rapidity of the process hinges largely on how important a role luck plays. In fact, you can infer the relationship between skill and luck by analysing past patterns of reversion to the mean.”
And what role does luck play if you are a Bukowski-type at the race track? How much of a bettor’s success can be attributed to any sort of skill or past experience?
“In some activities the competition is not another person or team, but rather the collective bets of others. Pari-mutuel wagers on horse races are a good example. In a pari-mutuel system the house pools all of the wagers, takes a profit, and then pays out the winnings based on the outcome. You don’t make money by being smarter than the bettor next to you or by knowing which horse has the best odds of winning. You make money when the collective misprices the odds. Studies of wagering on horse races suggest that the odds tend to be reasonable forecasts of actual outcomes. The important idea is that you are competing not against other individuals, but against the wisdom of the crowd. When certain conditions are satisfied, crowds are smarter than the average individual within the crowd. This pushes the observed outcomes toward the luck side of the continuum. This is a crucial observation in markets and in structured wagering.”
So maybe your best bet is to blindly put money on the stocks (or horses) the crowd is betting on right now, regardless of past performance. And then get out while you’re ahead, because reversion will always occur, sooner or later.
Do check out the full PDF file sometime here (http://www.lmcm.com/pdf/UntanglingSkillandLuck.pdf). His research on sports outcomes, in particular, are intriguing.