Thursday, October 12, 2017

The Success Equation

Success in most endeavours is a combination of skill and luck. As Michael L. Mauboussin explains in his book The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing, we have a tendency to decide we were skillful when we succeed and unlucky when we fail. We make many other mistakes as well when it comes to recognizing the role of luck in our lives. Mauboussin teaches methods of measuring skill and luck.

Some activities involve little or no luck, such as chess or checkers. If a chess master beats me soundly at one game of chess, he or she is likely to beat me another 10 times in a row. Other activities involve to skill at all, such as roulette and lotteries, unless you count not paying as a skill. A test of “whether an activity involves skill: ask whether you can lose on purpose.” If you can lose on purpose, there must be some skill involved. Most activities, like sports, business, and investing, combine luck and skill.

It turns out that there are statistical techniques to measure the contributions of skill and luck to success. For example, using such methods we can measure the amount of luck involved in single-season records of sports teams. From most skill to least skill we have the following ranking: basketball, soccer, baseball, football, and hockey.

Even though there is so much luck in sports outcomes, fans are quick to blame their heroes for the loss of a single game. But even if you don’t make that mistake, don’t be too smug. We also attribute way to much skill to CEOs who often just get lucky, and we definitely attribute too much skill to investors who get lucky in the markets.

One study found that skill at handling day-to-day finances increases to age 53, on average, and declines thereafter. I guess that means I can expect a low, slow descent that ends with an inability to tell door-knockers to get off my property.

With activities that involve a lot of luck, like investing, “the focus must be on process” rather than on outcomes. Reinforcing poor choices just because they work out well isn’t a good path to success. A challenge with focusing on process is that you have to know a good process. Mauboussin summarizes Benjamin Graham’s approach to value investing as an example of a good process. This approach worked well in Graham’s day, but even he was no longer an advocate of his methods back in 1976. Since then, the stock market has become much more competitive requiring ever more sophisticated means of outsmarting other investors.

Not many books leave me pondering their contents after I’ve finished reading them, but this is one such book. If you want to compete in a complex area where feedback is clouded by luck, such as active investing, it pays to understand the lessons Mauboussin teaches.

No comments:

Post a Comment