How Much Luck in Investing Success?

Michael Mauboussin: Thanks, Christine, great to see you.

Benz: Michael, you did a keynote presentation Wednesday in which you talked about the fact that investors tend to systematically overestimate the roll of skill and underestimate the role of luck in terms of making their investment decisions. Let's talk a little bit more about that. First, why does that happen? Why do we tend to believe that perhaps we’re better than we actually are?

Mauboussin: So, Christine, it's so interesting. There is actually a little part of the left hemisphere of our brains called the interpreter, and whenever we see an effect, for example, performance for our portfolio, we try to attach a cost to it. So, basically, it's this cause-and-effect loop that our minds are trying to close all the time. And whenever we see especially good results, our minds naturally think that that's because of skill.

Basically, the interpreter knows nothing about luck, so we can't really account for the substantial role of luck in investing. So, it's this very interesting natural phenomenon that we all do that when we see success, we associate it with skill, even if luck is the key contributing factor.

Benz: So, a follow-up question would be, how does that lead to behavioural traps? If we tend to believe that we are more skilful than we actually are, how can that get us into trouble when we're managing our own portfolios?

Mauboussin: I see two big behavioural traps. One, I'll say is mostly for money managers and that tends to be overconfidence, so a belief that they know what the future is going to hold to a greater degree than they actually do. And 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.

For individual investors, I think the way it shows up primarily 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. So, as you know, a very well-known fact, you guys have talked a lot about this, 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.

Benz: So, in terms of specific tactics that one might use to combat those bad behavioural tendencies, in terms of the range of outcomes, for example, that an investor might think about, would you say using maybe a devil’s advocate to help discuss different scenarios than the ones that perhaps you've considered? What can people do to combat those tendencies?

Mauboussin: That's a great idea, devil’s advocate. One is also looking at history, look at past results and look at, for example, past ranges of outcomes. And it could be fundamental things for a company, like sales growth rates or margins or stock-price performance. How much do stocks tend to move on average over time? Another technique I like, which is a little bit more advanced, is going to the options market. So, the options prices reflect ranges of possible outcomes. It's priced into those options, and if you're fairly sophisticated, you can divine those distributions from option prices. So, there are number of techniques that you can use to try to open up your mind to consider more alternatives.

Benz: You talked about a lot of human endeavours and where they fall on the luck-versus-skills spectrum. Where do you put investing in terms of success rates? Is that highly dependent on luck or skill?

Mauboussin: So, the continuum as you described is, we've got one side that is pure luck, no skills. So that'd be roulette wheels and so forth, and the other side is pure skill, no luck. It may be like a running race. And as you pointed out correctly, almost everything in life is somewhere between those two extremes. Investing is a particular interesting one. By the way, there is a really cool test as to whether there's any skill in activity, and that is ask if you can lose on purpose. If you can lose on purpose, there has to be some skill.

Investing is interesting in a sense that, for example, apply that test to it. 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. So I would just say, I don't know where to place it exactly. I think it's toward the luck side, but I do want to emphasize, and this is really important, is 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 skilful than others. The challenge is primarily figuring out who it is ahead of time. But we know ex post facto that there are skilful managers.

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. So, it's toward the luck side, but there is differential skill, and we still should be focused on trying to figure out who those folks are with skill and try to align ourselves with them.

Benz: Well, then next logical question is what common attributes do skilful managers have? Do you have any guidance to share on that for investors who are attempting to sort that out?

Mauboussin: Yeah, a couple thoughts on that. One is when I think of a great process, I typically think about three components to it: one is an analytical component, which is finding stocks with edge where you have a high expected return. And the second is position sizing, so once you have the edge, how do you put it into your portfolio. So, that would be the analytical bucket.

The second would be behavioural, which we've already talked about, which is we know that there are slew of these sort of behavioural pitfalls. Are you aware of those? Can you manage those as an investment organisation to try to damp down? You can never get rid of them.

And the third is what I call organizational, in which every organization has its own constraints and issues. Can we try to understand those things and minimize those things?

Now those are all interesting things, but sometimes as an investor it's hard to see in to figure those things out. So, the question are there any metrics, any statistics that may help you? And some of the statistics may be helpful and I think, again, it's early days, but something like active share and tracking error. So, active share is looking at how different your portfolio is than your benchmark. 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.

As a group they tend to do a little bit better than others. So, there might be ways to get some insight, and by the way, tracking error, importantly, and active share are within the control of the manager, so that is indicative of skill. So it's the process orientation and then maybe some tip-offs as to who is doing things well from a process point of view.

Benz: One thing we've seen is an increasing embrace of index products and you can sort of say by extension that investors are embracing randomness. They are saying, "Well, maybe I am not that skilful; I'll just cast my lot with the whole market." Does that seem to create opportunities potentially for active managers, if more and more investors are going with passive products?

Mauboussin: Let's say, if you go back, there was a very famous paper in the 1980 by Sanford Grossman and Joseph Stiglitz called "On the Impossibility of Informationally Efficient Markets," where they basically said, you need to have some active managers out there collecting information, reflecting it in prices in order for markets to be basically efficient. The passive world--and by the way I should say, index investing makes a lot of sense for a lot of people, so I don't want to dismiss that--but the fact is index investing relies on that basic activity in order to achieve the results it hopes to achieve.

We have a couple of pieces of evidence that have come along in research in the last couple years that stocks that are highly indexed, for example, tend to be somewhat less efficiently priced. I think it's kind of early days in that research, but that is something that's very potentially true that if we see too much indexing or too much sort of herd behaviour into certain types of products or areas that that absolutely will create opportunities for active managers on the other side of the trade.

Benz: When you think about some of the behaviour that investors have been exhibiting recently, they've been really gravitating to safe products or products they perceive to have safety--income-producing products, in particular, seem to be a strong area of interest--what does that say about how investors are acting behaviourally? And are they making good rational decisions, or what's going on there?

Mauboussin: I think that it's really a dearth of alternatives for lot of folks, especially if you are toward retirement age and you do require income in your portfolio. Obviously, just given the quantitative easing we see not only in our own government but across many sovereign governments, it's pushed yields down to really puny levels, so it becomes very, very difficult to get the kinds of returns that you need in the fixed-income market. So, of course, as you point out correctly, people are scouring alternatives to try to get some sort of yield.

But, of course, that's become very crowded. In fact, everybody is sort of doing the same thing. I think that is coupled with the fact that we've had a very challenging market. Even though the markets have been good the last couple of years, it's been very tricky. You had a bear market in the early part of the decade. You had better mid-2000s, but then as people were kind of lured back into the market, we had this horrible financial crisis. So I think a lot of people have found it very, very tricky over the last 10 or 12 years, and as a consequence have very fundamental lack of comfort in getting back into the market. So it's a combination of that, "Hey, we need to have yield just for our retirement portfolios," and "Gee, it's been a really treacherous environment, say last 10 or 15 years."

Benz: Michael, thank you so much for being here to share your insights.

Mauboussin: My pleasure. Thanks, Christine.

Benz: Thanks for watching. I am Christine Benz for Morningstar.com.