Saturday, March 12, 2011

Luck versus skill: How can you tell?

A hedge fund manager doubles her investors' money over the course of a year.. A company's stock increases four fold over the course of six months.... these are not unusual news stories but they give rise to one of those enduring questions in finance: Was it luck or skill? The answer of course is critical. If it was "luck", we should not be giving the hedge fund manager 2% of our wealth and 20% of the profits. If it was skill, the company's managers deserve not just a huge thank you but commensurate financial rewards.

As always in finance, there are two extreme outlooks. At one end, there are those who view any superior performance as evidence of skill and extended superior performance as almost super natural. At the other end, there are those who who contend that it is all "luck" and that portfolio managers have any "discernible skill". As an illustration, Fama and French have a damning article on active portfolio management, where they note that all of the excess returns in practice can be explained by randomness:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1356021
In their assessment, all "superior performance" in portfolio management  can be attributed to luck. Here is a more recent paper by Andrew Mauboussin and Sam Arbesman that argues that there is some evidence of differential skill:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1664031
Needless to say, this is an issue where researchers have disagreed and continue to do so.

You may disagree with the broadness of the Fama/French conclusions (and I do), but they do point out how difficult it to differentiate lucky winners from skillful winners. To understand why, it is best to look at an arena where the differentiation between luck and skill is easier: sports. Even those who don't like Sachin Tendulkar, Lionel Messi, Tiger Woods or Kobe Bryant have to admit that they have skills the rest of us don't possess and that their success cannot be attributed to luck.  So, why is it so easy to separate skill from luck in sports and not so in finance? Separating luck from skill is easiest when:

a. Success is clearly defined: In basketball, you either make a basket or you do not. In cricket, you are out or you are not. In golf, you make par or you do not. In soccer, you score a goal or you do not.  An "almost a basket" or "almost par" can be a chatting point with a friend but does not count.

b. It is difficult to have a successful outcome with just luck: I will make a confession. I cannot shoot par on a golf course, make a three pointer in basketball or score a goal in soccer, even with luck.  I am awed when I see people do these things, since I know it requires skills that I do not have.

c. Number of trials: Professional sports players get hundreds of chances to show their wares, and luck very quickly drops to the wayside. You may make one three-pointer in the gym, with sheer luck, but if you were asked to shoot a few hundred three pointers, your limitations would be clear to all. There is no way that luck can explain the hundreds of sub-par rounds that Tiger Woods had (when he was a golfer and not a celebrity), the runs that Sachin scored for India, the points (and championships) for Kobe and the goals that Messi has scored for Argentina (and Barcelona) over time.

Looking at finance through these lens, it is easy to see why it is so difficult to separate luck from skill:

a. Success is not clearly defined: Is a portfolio manager who makes money for his investors a success? What about one who beats the S&P 500 each year? Is a company that delivers returns that outstrip the rest of the sector a success a "good" company? The very fact that we have to think about our answers to these questions tells you something about "success" in finance. To be successful, you have to beat your benchmark, after controlling for risk. However, since risk is a subjective measure, it is entirely possible for a portfolio manager to be classified as a success by one evaluator and not by another. With hedge funds and private equity managers, it becomes even more so, since the net risk exposure is often tough to measure.


b. It is easier being successful with just luck in finance:  I would not bet my house that my portfolio selections will deliver higher returns in the next year than those of my neighbor, who picks stocks based on astrological signs and has the financial sense of a dodo, or of my 11-year old son, who has never looked at the Wall Street Journal. As I note in my valuation class, there is no justice in the investing world. You can do everything right (collect the data, analyze it carefully, make reasoned judgments) and go bankrupt... and you can be absolutely cavalier in your investment judgments and make millions.

c. Too few trials: Can you be lucky once? Sure! How about 4 times in a row? Yes.. How about 15 years in a row? Not as easy, but with hundreds of people trying, a few will.... One problem that we face in portfolio management and corporate finance is that we get to observe outcomes too infrequently, making it difficult to separate luck from skill.

I don't mean to leave you in limbo. After all, most of us want to separate luck from skill in finance. So, here are the things that I would look for in a "skillful" portfolio manager or a CEO:

a. Consistency: As an investor, I don't want to just see that you beat the market, on average, but that you beat it consistently for an extended period. I am more likely to attribute your success to skill, if you beat the market by 2-3% each year for 15 years than if you beat the market by an average of 2-3%, with more variability and poor years intermixed, over that period.

b. Transparency: I tend to mistrust success, when that success is based on portfolio managers self-appraising the values of the properties and investments in their portfolios. A hedge fund may claim it made a 30% return last year, but if that return was based on appraised values for non-traded assets, did it really make 30%? If your success is based on skill and not luck, you should have as open a process as possible for measuring returns and risk and allow investors to observe that process.

c. Awareness: If you beat the market, you are pulling off a difficult feat, since there are literally millions of investors attempting to to do the same thing. If it is not luck that is causing the superior performance, you have to be able to point to something that you are bringing to the table that others are not - better information, better analytical tools, a longer time horizon or a very different tax status. If you don't know why you are beating the market, rest assured that you will not be beating the market for very long..... In my experience, the most skillful investors tend to not only be the most self aware (of their strengths and limitations) but also have no qualms about letting you know what their investment philosophy is. (Note that you can be secretive about investment strategies but you give away little by sharing an investment philosophy).

d. Humility: This is my subjective input to the process. In my years in the market, I have discovered that it is the lucky investors (with no skill) who are most hot headed and arrogant about their skills, and that skillful investors recognize how much luck can affect their final returns.

Here is my bottom line for a skillful portfolio manager or CEO: I am looking for a person who has been able to deliver performance that beats the competition consistently over many years, can tell you why he or she can pull this off and is willing to concede that luck could explain the whole phenomena....

Update: A couple of you have drawn my attention to Mike Mauboussin's excellent and extended discussion of the topic.
www.lmcm.com/pdf/UntanglingSkillandLuck.pdf
Mike is one of my favorite thinkers in finance - he is always original and manages to think across disciplines - and I don't know how I missed this piece but he says what I was trying to say much better than I ever could, and in much more depth. Do read it!

14 comments:

John said...

The discussion starts a few minutes in ...

http://www.dimensional.com/famafrench/2010/10/future-of-money-management.html

Mohit Rathi said...

Very nice one professor. Simple yet precise.

Balaji said...

Good article Aswath, the problem we face is that we have managers who often have the skill to dress up 'luck' as one of their skills in being able to take advantage of opportunities aggressively. Risk ofcourse is an important factor and in hindsight everyone can prove they are a winner.

Consistency, as you say is the key measure!

Gaurav Mehta said...

this one does explain a lot to me... :)

C. Fuzzbang said...

I would say that having worked in the industry, many participants actually believe it is luck. That is why so many put so much effort into marketing. Why spend on research when it's irrelevant? Better to convince the client that you are good than be good.

The biggest issue concerning people who want to place money at an investment firm is even if you can, without a doubt, calculate that the asset manager is skilled rather than lucky (which you can't) there's nothing to say that the makeup of the team that contributed the skill will be around tomorrow. In most cases, teams with great records dissolved as individuals were offered better jobs.

Immortal said...

Warren Buffet signifies the difference between luck and skill in the world of investment and finance...You can easily relate to all the 4 elements that differentiate between skill n luck..Prof do u agree with me??

Aswath Damodaran said...

Absolutely. My disagreements with Buffett are not about his investing genius. In fact, I highlighted Buffett in my book on investment philosophies as someone who has a well thought out philosophy and has stayed true to it over the decades.

VIKRAM said...

Good article Sir. My point is in the world of Finance Science only people with high skills can be lucky & not the other way around.

GOVIND GADIYAR said...

The problem is we do not stick to our thought out investment philosophy or we do not have one to begin with. At least this is my observation while studying Indian market.

Aswath Damodaran said...

Vikram, You have far more faith in skill winning out in investments than I do... And Govind, this is true in every market...

TJ said...

One issue comes to mind. In investing, one can be be skilled and yet perform poorly (hence, labeled unskilled). For example, one might correctly determine that a stock is overvalued and short sell it. The problem is if others in the market do not believe that the stock is overvalued, correction might not occur and in fact, the stock might continue to rise, resulting in short-selling losses (noise trader risk).

That is where in my opinion investing differs from sports. In sports, skill can be acquired. I am not much of a soccer player, but if I play soccer daily for few hours for extended period of time under guidance, I think I could be pretty good. In investing, you are subject to the vagaries of the market. Unlike sports, your success is not the result of your own skill only; it really depends on correctly figuring out the collective psychology of all investors and that is something I believe is almost impossible to figure out consistently. I think the odds are stacked against identifying skilled investors (as compared with identifying skilled sportsmen).

VIKRAM said...

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sunil k said...

@TJ...i am new to this field but i feel it is similar to sports ... yes you are right that if u play everyday you will become good player of soccer..but again the sport is also a relative valuation..here one have to compete with others to be a good player.
similarly in the field of investment ..the more we study..the more we analyse..the better will be the result..the better will be skill if we know where we are investing i.e. again knowing fully the specific investment.

Faisal said...

Also, a point that Nassim makes in his book "Fooled by Randomness" is that the sample has increased a lot over the years. There are a lot more people in finance right now so we are bound to get a high proportion of 'winners' i.e. successful portfolio managers