Luck mostly dictates investment results in the short term, according to Credit Suisse’s Michael Mauboussin.
In a new video from the bank, Mauboussin explains the skill/luck continuum that determines relative investing success. From Credit Suisse:
Examples of the first end of the continuum — pure luck, no skill — could be roulette wheels, lotteries or similar kinds of things. Pure skill, no luck might be running races or a chess match. Almost everything is arrayed somewhere in between. For example, sports like basketball are actually much closer to being all skill. Ice hockey is much closer to being all luck. Thinking about your decisions, the key is to knowing where your activity lies on that continuum.
A lot of investment results — especially in the short-term — are based on luck, but maybe not for the reason that people believe. There is a lot of skill in markets and investors themselves are all very similarly skillful — this is reflected in prices. As a consequence, that leaves more to luck and is the reason why short-term outcomes can mostly be put down to luck. Having said that, any serious study of past investment performance demonstrates that differential skill does play a role. Some investors clearly have more skill than others. But, by and large, especially in the short-term, luck mostly dictates the results.
Mauboussin goes on to talk about the “dumb money effect,” when investors leave the market during bad times and miss out on the rally.
The dumb money effect shows some of the most depressing statistics in investing. If you look at a market return — for example the S&P 500, or any index — it comes in at say 9 per cent over the last 20 years. The average fund does a little bit less than that — primarily because of fees — but the average investor does quite a bit worse than the average mutual fund. It is a little perplexing. You might ask how investors do worse than the funds they are investing in. The answer is the dumb money effect, which is, people tend to invest when things are good and they tend to pull their money out when things are bad. Because they invest when things are good, they then have subsequent underperformance. They then pull their money out when things are bad so they miss the subsequent rebound. So, the dumb money effect basically says that people do what they should not do all the time. Bad timing is at the heart of this.
Watch the video: