Luck and skill in investing are easy to name and hard to separate. In this companion piece to the latest Sweat Your Assets podcast and YouTube episode, Michael Mauboussin offers a simple test to locate any activity on the continuum between pure chance and pure skill, explains why improving skill paradoxically hands more influence to luck, and makes the case for judging your decisions by process rather than outcome.
Luck and Skill in Investing: Lessons from Michael Mauboussin
Could You Lose on Purpose?
Sit down at a chessboard with the firm intention of losing, and you will manage it within a few moves. Chess is a game of pure skill, and skill can be switched off. Now try the same experiment at a roulette table. You cannot lose on purpose any more than you can win on purpose, because there is no skill to switch off. This little test, asking whether you can lose deliberately, turns out to be one of the most useful diagnostic tools in finance.
Apply it to investing. We know it is remarkably difficult to build a portfolio that reliably beats the market. What is less appreciated is that it is almost as difficult to build one that reliably does worse. Anyone who has paid active management fees through years of underperformance may find this hard to believe, but even the underperformance is rarely consistent enough to qualify as a skill. The conclusion is uncomfortable: investing sits much closer to the luck end of the spectrum than most of its practitioners would like to admit.
The test comes from Michael Mauboussin, head of research at Counterpoint Global at Morgan Stanley, adjunct professor of finance at Columbia Business School, and author of The Success Equation. In the latest episode of the Sweat Your Assets podcast, I stepped back from my usual commentary and handed the microphone to him. The episode is a curated and annotated audio version of a lecture he delivered at the Santa Fe Institute, and the full video, with all the slides and charts, is on the Sweat Your Assets YouTube channel. This article distils the ideas that deserve a permanent place in an investor’s mental toolkit.
A Continuum, Not a Coin Toss
Mauboussin’s starting point is disarmingly simple. Place every activity on a continuum. At one extreme sit pure luck activities such as lotteries and roulette. At the other sit pure skill activities such as chess and running races. Everything else in life falls somewhere in between, and every outcome you experience can be imagined as one draw from a skill distribution added to one draw from a luck distribution.
Skill he takes straight from the dictionary: the ability to apply your knowledge readily, on cue, when called upon.
Luck is slipperier, and he pins it down with three conditions. It operates on an individual or an organisation, so it happens to you, your firm or your portfolio. It can be good or bad. And a different outcome could reasonably have occurred: if you rewound the tape of time and played it again, things might have gone another way. When all three conditions hold, luck is in the room.
Outliers and the Pull of the Average
Two lessons follow immediately from this model. The first concerns outliers. Whenever you observe an extraordinary result, you are almost certainly looking at extreme skill combined with extreme luck: the right tail of one distribution stacked on the right tail of the other. Skill is the prerequisite, and luck is the amplifier. Most of the outliers we ever get to see are positive ones, because the negative outliers tend to disappear from view, literally or metaphorically.
The second lesson concerns reversion to the mean, a concept everyone can recite and almost no one truly absorbs. Outcomes far from average tend to be followed by outcomes closer to average. What Mauboussin adds is that your position on the continuum determines the speed of that reversion. Race Usain Bolt over a hundred metres and he wins. Race him again, and he wins again. Pure skill reverts to nothing. Pure luck, by contrast, reverts completely and immediately. Investing, sitting near the luck end, reverts fast, which is precisely why last year’s chart-topping fund so often disappoints this year’s buyers, and why I have argued elsewhere that market forecasts fail, and that is fine.
The Paradox of Skill
The idea from the book – The Success Equation – that has attracted the most attention is what Mauboussin calls the paradox of skill: as skill improves in a field, luck becomes more important in determining outcomes. This sounds backwards until you separate absolute skill from relative skill. In almost every domain we can measure, from athletics to business to fund management, absolute skill is higher than it has ever been. But relative skill, the gap between the best and the rest, has collapsed. Baseball offers the cleanest evidence: the standard deviation of batting averages has narrowed steadily for decades, exactly as the model predicts.
The implication for investors is sobering. You are not competing against the market of 1960, populated by part-timers and dentists trading on tips. You are competing against a dense field of highly trained professionals armed with the same data, the same models and the same incentives. When everyone is brilliant, brilliance stops being the differentiator, and chance decides the residual.
Stephen King’s Accidental Experiment
Some processes are largely independent, meaning what happened before barely affects what happens next. Others are path dependent, meaning history compounds. For path-dependent processes, Mauboussin argues, we should expect inherent unpredictability and inherent inequality, and he illustrates the point with one of the best natural experiments in publishing history.
By the late 1970s, Stephen King was writing faster than his publisher would print, so the surplus novels went out under the pseudonym Richard Bachman. King’s books sold spectacularly. Bachman’s flopped, year after year, until a Washington bookstore clerk noticed the stylistic resemblance, checked the copyright records at the Library of Congress, and unmasked him. From the moment the true authorship was revealed, sales of the same book rose roughly tenfold. The words had not improved. J.K. Rowling repeated the experiment involuntarily in 2013 as Robert Galbraith, with the same result. Quality is a prerequisite for success in creative markets, but it is nowhere near a guarantee, and even the world’s largest movie studios freely admit they cannot predict hits despite every incentive to do so.
The Storyteller in Your Head
If the future is a mix of luck and skill, we accept it calmly. The trouble begins the moment an outcome lands, because our minds immediately manufacture a story to explain it. Two distortions follow. Hindsight bias convinces us we knew all along what was going to happen. Creeping determinism convinces us that what happened was the only thing that could have happened. Jonathan Gottschall, in The Storytelling Animal, describes the storytelling mind as “allergic to uncertainty, randomness, and coincidence”, so much so that when it cannot find a meaningful pattern, it will impose one.
This is not a philosophical curiosity. Researchers examined roughly twenty bestselling business books of the Good to Great variety, covering around seven hundred companies, and asked how many of those companies could be confidently classified as skilful using fifty years of corporate data. The answer was about twelve percent. The rest were plausibly there by luck, and, true to rapid reversion, the performance of many featured companies rolled over almost as soon as the books were published. The books still sold millions of copies, because they tell beautiful and motivating stories. Good science they are not.
I recognise the pattern from twenty-five years in development finance, an industry that runs on project reports. Success stories are drafted after the harvest comes in. The same programme design reads as visionary after a good rainy season and as naive after a drought, even though the design was identical in both cases. Donors, much like readers of business books, tend to reward the better narrative rather than the better process.
Judge the Process, Not the Outcome
So what do we do with all this? On the skill side of the continuum, the prescription is familiar: deliberate practice at the edge of your ability, with a coach and fast, accurate feedback. There, output genuinely reveals skill. Watch someone play tennis or piano for ten minutes, and you know how good they are.
Slide towards the luck side, and that connection breaks. A blackjack player can play foolishly and win, or play perfectly and lose. In such domains the only sensible object of evaluation is the process behind the decision, which Mauboussin splits into three components: an analytical component, a behavioural component concerned with recognising and mitigating bias, and an organisational component that asks whether outside influences are quietly degrading your decisions. This is the deep logic behind diversification, written investment rules, rebalancing and the study of cycles rather than forecasts.
It is also why the great investor Howard Marks insists that the essential question is not where the market is going but where you stand in the cycle, and it is one of the four ways of looking at financial markets I keep returning to. Howard himself commented on the inherent relation between luck and skill in this interview (You cannot judge a decision by its outcome).
Luck itself cannot be improved, whatever the aphorisms about hard work suggest. Hard work is not luck; hard work is a skill. But luck can be managed. If you are the stronger player, simplify the game so your skill dominates. If you are the weaker player, complicate it: disruptive innovation in business, guerrilla tactics in warfare, trick plays on a Sunday afternoon. And wherever possible, make many small bets and let the results tease out causality, which is all that A/B testing really is.
Takeaway: where luck dominates, judge decisions by the quality of the process, not the outcome. A good outcome from a bad process is a loan from luck, and luck calls in its loans.
Listen to or Watch the Full Episode
This article only skims the lecture. The curated audio version is now available on the Sweat Your Assets Podcast on Spotify and Apple Podcasts. You can also watch the full episode on the Sweat Your Assets YouTube channel.
Keep it real. Sweat Your Assets.