Is Individual Investing Success More a Matter of Luck or Skill? ... The Good News is That We Don't Need Much of Either to Be Successful Individual Investors

Individual investing success is generally attributed to a combination of luck and skill. But what percentage do we assign to each? To which I say, who cares?

In my view, apportioning the relative causes of investing success between luck and skill is totally unnecessary. And that's due to the fact that in large part individual investing success doesn't require either luck or skill.

Success is much more related to how our money is invested, how long it's invested and in what mix of assets it's invested. And of course, how early in life we began investing as well.

Is Your Manager Skillful...or Just Lucky? compares the elements of skill and luck in investing results as follows:

"Investors can track, to a hundredth of a percentage point, how individual mutual funds are performing relative to their market benchmarks. But they are largely powerless in determining the degree to which a fund manager's results are a function of skill—and how much they are attributable to just plain luck.

To explore that, we spoke with Michael Mauboussin, the chief investment strategist at Legg Mason Capital Management unit and the author of a new book, "The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing."

The following are edited excerpts of the conversation with Mr. Mauboussin, who has worked at the fund-management firm since 2004 and has been an adjunct professor of finance at Columbia Business School for 20 years.

Abundance of Skill

 "WSJ: In the book, when you put certain activities on a continuum from being all luck to all skill, you show investing as having a much larger quotient of luck than winning at football or baseball or chess. You say that is partly because so many smart people play the investing game?

Mr. Mauboussin: Exactly. It's very counterintuitive. The key is this idea called the paradox of skill.

As people become better at an activity, the difference between the best and the average and the best and the worst becomes much narrower. As people become more skillful, luck becomes more important. That's precisely what happens in the world of investing.

The reason that luck is so important isn't that investing skill isn't relevant. It's that skill is very high and consistent. That said, over longer periods, skill has a much better chance of shining through.

In the short term you may experience good or bad luck [and that can overwhelm skill], but in the long term luck tends to even out and skill determines results.

WSJ: You say people generally aren't very good at distinguishing the role of luck and skill in investing and other activities. Why not?

 

Mr. Mauboussin: Our minds are really good at linking cause to effect. So if I show you an effect that is success, your mind is naturally going to say I need a cause for that. And often you are going to attribute it to the individual or skill rather than to luck.

Also, humans love narratives, they love stories. An essential element of a story is the notion of causality: This caused that, this person did that.

So when you put those two together, we are very poor at discriminating between the relative contributions of skill and luck in outcomes.

WSJ: If I accept that a big part of investing success is luck, not skill, isn't that a strong argument to simply go with index funds and not try to pick active managers?

Mr. Mauboussin: Indeed. For someone who has little motivation to try to identify those who have differential skill, indexing makes a lot of sense.

Spotting a Winner

WSJ: Is it possible for individual investors to identify in advance mutual-fund managers who are truly skilled and not just lucky?

Mr. Mauboussin: You can make a credible effort if you are motivated, yes.

A manager may do the right things and get bad outcomes or do the wrong things and get good outcomes. So investment results can be very deceptive.

The better way to do it is to focus on the process of decision making that managers use and to look for numerical measures that can be proxies for that. . . .

Mr. Mauboussin: If you look at streaks, not just in investing but in any endeavor, almost by definition they combine skill and luck. You have to have above-average skill and above-average luck to have a streak. If you look at it in the realm of sports, all the streaks are held by the most skillful players, although not all skillful players have streaks."

Summing Up

Stocks outperform alternative forms of investment over a long period of time.

Accordingly, the best idea is to buy stocks and keep owning them over the years.

For the beginner, a low cost index fund such as the S&P 500 Equity fund offered by such families of funds as Vanguard and Fidelity is probably the most appropriate investment vehicle.

As the beginner progresses in his knowledge and becomes more comfortable owning stocks, he should begin to transition his investment portfolio into the direct ownership of individual stocks. 

A well diversified portfolio of stocks would eventually include stocks in each of the following ten sectors: consumer discretionary; consumer staples; telecommunications, utilities, materials, financials, health care, information technology, energy and industrials. We'll discuss all this at a later time.

Picking individual winners isn't important to being a successful individual investor and outperforming the pros. That's due to one very simple reason.

The vast majority of professional managers don't outperform the S&P Index when fees, trading costs and taxes are considered. They don't even come close.

If we ever get to picking the winners, we'll be in that rarest of categories. We'll be a 1%-er among the pros.

In the long term, neither skill nor luck is essential  to individual investing success. Not necessary at all.

Thanks. Bob.