Is It Skill, or Luck?

Are successful investors good, or just lucky? In a recent interview with Morningstar, Credit Suisse’s Michael Mauboussin says they’re luckier than you think — but still have some skill.

Mauboussin, who has done extensive research into the topic of skill vs. luck, says one way to test whether any skill is involved in an activity is to see if you can lose on purpose. “If you can lose on purpose, there has to be some skill,” he says. In investing, he adds, “we know that it’s hard to create a portfolio that beats a particular benchmark, but actually given the same parameters, it’s actually pretty hard to build a portfolio that does a lot worse than the benchmark. So that tells you right away that we’re toward the luck side.” But Mauboussin also stressed that “every piece of research that’s been done on this [shows] there is differential skill in money managers. There are managers who are more skillful than others. … So, it’s not completely on the luck side, and there is a big difference between being mostly luck and all luck. And especially as you expand your time horizons, skill does tend to reveal itself.”

Mauboussin says skillful managers tend to have a few qualities in common. First, there’s an analytical piece — being able to find stocks with an edge and a high expected return and using smart position sizing are both key.

Managing behavioral biases is also critical, however, he says. He sees two big behavioral traps. The first (mostly for money managers) is overconfidence. “The way that typically shows up is projecting ranges of outcomes that are vastly too narrow, so they don’t take into consideration all the possible outcomes,” he says. For individuals, the trap is performance-chasing. “We tend to buy things that have done well only to suffer for the subsequent corrections, and we tend to sell things after they’ve done poorly only to miss the potential rally as a consequence,” he says. “So, as you know, a very well-known fact … markets have returned, say, 8% or 9% over the longer term, and mutual funds have returned little bit less than that. But the average individual investor only earns about 50% to 60% of the market returns primarily because of bad timing. So trying to get rid of that bad timing I think is one of the best possible ways to improve on the behavioral elements.”

Mauboussin says some metrics can be helpful in finding skillful managers, like active share (which measures how different your portfolio is than your benchmark) and tracking error. “It turns out high active share tends to be reasonably associated with good returns, but you don’t want too high tracking error, which is sort of making a lot of factor bets. So it’s something that’s different than the portfolio via stock-picking but not making big factor bets,” he says.