February 9, 2016

Paradox of skill and luck

Michael Mauboussin discusses a very interesting concept called the paradox of skill in his book 'The Success Equation'- Untangling Skill and Luck in Business, Sports, and Investing'. “As skill improves, performance becomes more consistent, and therefore luck becomes more important,” is how Mauboussin defines the paradox of skill.

The Olympic marathon is a very good example of the same. Men run the race today about 26 minutes faster than they did 80 years back. Also, in 1932, the difference between the man who won the race and the man who came in twentieth was 40 minutes. Now its less than 10 minutes.

Now the question is how does this apply to investing? “As the market is filled with participants who are smart and have access to information and computing power, the variance of skill will decline. 

That means that stock price changes will be random and those investors who beat the market can chalk up their success to luck. And the evidence shows that the variance in mutual fund returns has shrunk over the past 60 years, just as the paradox of skill would suggest,” says Mauboussin. “I want to be clear that I believe that differential skill in investing remains, and that I don't believe that all results are from randomness. But there's little doubt that markets are highly competitive and that the basic sketch of the paradox of skill applies,” he adds.

Nassim Nicholas Taleb writes in 'Fooled by Randomness', “In real life, the larger the deviation from the norm, the larger the probability of it coming from luck rather than skills...The “reversion” for the large outliers is what has been observed in history and explained as regression to the mean. Note the larger the deviation, the more important its effect.”

Source: https://www.valueresearchonline.com/story/h2_storyView.asp?str=24177

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