'If nothing else, the discussion of skill and luck makes clear why focusing on outcomes is less useful than focusing on process. If luck nets to zero over time - you win some, you lose some - then long-term results depend on the process.' - Michael Mauboussin

Skill & Luck

How do you differentiate skill and luck? You might be making 100-200% return in 2014 but is that just luck or skill? 

Just like how the author demostrate coin flipping with 400 students, 2 students made the right call for 7 consecutive tosses. Those are merely pure luck, no skills required. 

Let's be honest, this is a boring topic for most. 99.9% of people would rather read some juicy tips that they can make money on than learning this because the reasoning goes, as long as I am making a profit, else doesn't matter.

However if you are the reading this now, and spend some time reading the article and do some thinking, you will be glad you did. 

Why is it so important?

Why is understanding skill and luck so important? Because investing consist both skill and luck, and luck plays a majority of it. You can be making lots of money when luck is on your side, just like the coin flip example above. On the flip side, you are just as likely to lose as much money as you win.

Using another coin flipping example, you might flip a streak of head for 8 consecutive time (head = make lots of money) but over the long term of flipping 10,000 times, your chance of getting a head or tail is very close to 50/50, means what you win you will lose back, what you lose you will win back, evens out. Except that you will still make a lose, because of transaction fees in investing. This is a statistical phenomenom. 

Reversion to the Mean

Tennis is a game that is close to pure skill, that is why there are only a few top tennis players, you don't see that many lucky tennis player. There is no reversion to the mean.

Anything that consist the element of luck will eventually fall back to the mean, the average, like the coin example above. You might swing too many head or tails in the short run, but long term it will revert back to the middle, 50/50. 

So if you are making lots of money right now, don't be too excited or surprised if it is pure luck. If you are still reading by now, you know this is more juicy than making money. 

Process > Outcomes

This brings us back to the quote above, if luck nets out zero over time, outcomes doesn't matter, what matters are the process. 

I am never a big fan of 'Self invented investing strategies' if you strategies are not grounded on some basis of fundamental framework or concept but rather some mystical beliefs, it is likely you are being fool by randomness. 

What you have to learn is getting your investing process right, don't focus too much on the outcomes. Learn how to invest successfully (process), not how to make money (outcomes). 

Cut through the noise

Sadly there is no easy way to differentiate skill and luck, the 2 main ways are persistence of performance and reversion to the mean. 

Persistence of performance means if a certain performance can consistently outperform beyond what can be explained by randomness of luck, and it does not revert back to the mean, then you know skills exist. 

This is also why I am against creating your own gimmicky investing strategies unless there is a sound fundamental behind it. Rather save yourself some time, study the thought processes of successful investors. Just like if you want to be successful in business, study how successful businessmen thinks, their thoughts. 

Save yourself some time from so called sifu or guru on here or any forum or any Facebook investing pages and spend your time wisely reading more books. 

A good investment process

The author offered what comprises a good investment process. 3 parts:

1. Find situations where you have analytical edge 
2. Temperament
3. Costs (For Institutions)

Finding analytical edge - An analytical edge is the ability to distinguish between fundamentals (value) and expectations (price). 

Temperament - Again, temperament or behaviour counts a lot when it comes to successful investing. Analytical edge is at the highest during extreme bull or bear market condition, that's also when many people crumble if you don't have the temperament to execute your investment process. 

Summary

I strongly recommend you download and read the whole article. The article involve a lot of statistics on sports, business and investing. However if you really must, read the conclusion part starting page 24, that's where all the key points about investing are. 

Pages: 27

Author: Michael Mauboussin

Links: https://www.dropbox.com/s/2ut7fkhq5cnt4i9/Untangling%20Skill%20%26%20Luck%20-%20Michael%20Mauboussin.pdf?dl=0

Size: 972kb