Michael Mauboussin on the Role of Luck and Skill in Investing
Adjunct Professor of Finance, Columbia Business School, and former chief investment strategist at Legg Mason, Michael Mauboussin was interviewed by Consuelo Mack of Wealthtrack. Mauboussin has authored several books, the latest being The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing. Mauboussin’s book examines the roles of luck and skill in investment success.
Mauboussin said it turns out that luck is very important, especially for short-term results, but not for the reason most people think. He referred to the paradox of skill, in that luck is important because most investors are so skillful.
Mauboussin used a sports analogy to further explain his point. No one has achieved a .406 batting average since Ted Williams did it in 1941. Stephen J. Gould, Harvard biologist, wrote an essay examining how Williams’ record could stand for so long and came to the conclusion that was was because everyone had gotten better. The variance between the best and the worst players has become smaller over time and batting averages have come down, according to Mauboussin. If Williams were playing today the equivalent statistical batting average would be .380, Mauboussin added.
Mauboussin further explained that our brains have a tendency to attribute past performance to skill. This leads to the biggest investment mistake in that investors scan for funds that have done well, attribute it to skill, and invest accordingly, he said. In effect, investors and institutions buy what’s hot and get rid of what’s cold, he added. Investors lose about one percent a year from this tendency to buy high and sell low, Mauboussin said.
Mauboussin differentiated where skill is dominant such as in sports and music, as opposed to the investing world which is more probabilistic. He referred to successful investing as a process. Maboussin said successful investing has three components to the process; 1) analytical (finding stocks for less than they’re worth and weighting them properly in a portfolio), 2) having an awareness of biases, including overconfidence, and 3) organizational, which refers to the investment organization’s primary interests and investment costs.
The interview (available below) continued with Mauboussin discussing indexing and active management, the concept of “active share,” whether investors should focus on macro issues, the two-step process to determine whether a statistic is useful, the effect of bad timing on investor returns, the importance of counterbalancing investor emotions, research done on the concept of “arc of skill” or peak ages of performance in investing, and the investing theme he would focus on (overweight stocks as compared to bonds due to the high equity risk premium).