Separating Luck and Skill in Investing Performance?

[Donald]

This is a somewhat abstract topic - difficult to get to grips with. I have been struggling to come to terms with this from mid 2015 or so. My thinking is still work-in-progress, but as usual I am excited enough to make bold to take this discussion forward at VP. The attempt is to evolve a framework based thinking on separating Skill from Luck - getting better at investing decision-making - with copious help from all the bright minds at VP. Inviting fresh views from folks interested.

A. Luck and Skill Continuum

This has been sort of an eternal question for me - ever since I understood (somewhere around late 2013) that we at VP had been extremely lucky. Extremely lucky to start in 2009 with typical beginners luck of a bear market. Extremely lucky to have attracted very talented hardworking folks like Ayush Mittal, Hitesh Patel, Abhishek Basumallick (and many more) to closely work with. Even more luckier that we attracted Mentors like Mr D and Mr M (anyone who has followed our Capital Allocation thread should be aware of them) to guide and prod us in our journey/learning curve.

Meanwhile most of our businesses we picked (VP Public portfolio) continued to perform exceptionally well, and Mr Market continued to reward. I started wondering about luck and skill in our choices, but couldn’t make much headway. The purists anyway attribute most outcomes to randomness (one outcome happening out of a range of possible outcomes) – an unsatisfactory response for an individual on a quest for a Luck vs Skill Framework. Quizzing my friends & seniors then, did not yield much either.

However by early 2015, I did run into the Success Equation by Michael Mauboussin – which finally provided something tangible for me to start grappling with.

Mauboussin says “Some activities allow little luck, such as running races and playing the violin or chess. In these cases, you acquire skill through deliberate practice of physical or cognitive tasks. Other activities incorporate a large dose of luck. Examples include poker and investing. In these cases Skill is best defined as a process of making decisions.”

Re: Process
One could reckon that how much luck is involved determines the range of outcomes - where little luck is involved, a good process will almost always lead to a good outcome. Where a measure of luck is involved (like in Investing), a good process will usually have a good outcome, but (perhaps consistently) only over longer periods of time.

At the heart of making this distinction lies the issue of feedback. On the skill side, feedback is clear and accurate, because there is a close relationship between cause and effect. The fastest swimmer will almost always win the race. The outcome is determined by skill, with luck playing only a vanishingly small role. Feedback on the luck side is often misleading because cause and effect are poorly correlated in the short run.

The luck/skill continuum in investing is almost entirely a function of sample size/time. Over shorter periods, our results are highly contingent on luck and chance. We might see a bad process provide excellent results due entirely to chance and a good process provide poor results for the same reason. Sustained performance over the longer term - i.e. repeatability of successes - however, may provide clues to a good process/better skill.

Mauboussin also says "As we move from right to left on the continuum, luck exerts a larger influence. It doesn’t mean that skill doesn’t exist in those activities. It does. It only means that we need a larger number of observations to make sure that skill can overcome the influence of luck.

While the sample size of our decision-making process is undoubtedly small (over 2010-2017 and will grow over time), I still want to go ahead at this stage of our investing journey and explore a case for Expertise/Skill as distinguished from Experience.

[Donald]

I am taking the liberty to deliberately quote from the Success Equation book, but often (mischievously) towards a different context - more suited to the above pursuit. Please excuse the several shortcomings.

B. Separating Experience & Expertise

Mauboussin says, in considering skill, it is also important to distinguish between experience and expertise. There is an unspoken assumption that someone doing something for a long time is an expert. However very few individuals are willing to devote the time and effort to go beyond a plateau of performance that’s good enough.

The process of acquiring Investing Skill (or, any skill for that matter) typically follows three stages.

1. Cognitive: We try to understand the activity and make a lot of errors. This is the stage when the learner has to think a lot about the skill and how to execute it. Performances will be inconsistent. Having a Coach (who’s been there done that) available proves very helpful.
   (I would hazard a min of 2-3 years spent here, by even the most hungry learners)

2. Associative: In this stage, our performance improves noticeably and we make fewer errors that are more easily corrected. While the simpler parts of the skill now look fluent and are well learnt (SCIENCE part), the more complex elements now require most of the spare attention (ART of Valuation, e.g.). Learners are starting to detect and correct their own errors.
   (Again a min of 3-4 years spent here perhaps, by most hungry passionate learners)

3. Autonomous: In the final stage of continuous learning, performances (are supposed to) become much more consistent, habitual and fluid. At this stage the learner has the bandwidth and time to REFLECT - to explore on his own - what works for him, and why - develop an individual style. Break his/her comfort zone, be open to adopt best practices from other successful styles
   (Post the first 7-10 years, lifelong refinement/practice continues, albeit at a much slower pace. Performance plateaus. Most are content at the status quo. Except for the most hungry, very few challenge themselves to force deliberate continuous refinement.)

Mauboussin goes on to say, most of us hit a plateau in our skills and are perfectly content to stay there. Once at that plateau, additional experience does not lead to improved results. What distinguishes elite performers, or experts, from the rest of us is that they advance beyond their natural plateaus through deliberate continuous refinement/practice.

The fact is, most of us generally don’t need performance that’s better than good enough. An experienced auto mechanic, plumber, or architect, for instance, is often all we need. Similarly, an experienced Investor is often good enough, for the job. Those who want to acquire real expertise though, force themselves out of the plateau/status-quo, continuously challenging themselves and their peers for the next level of refinement in investing process/skill.

[Donald]

Having digested the above 2 precepts (and examining where we were on the plateau ), I came across perhaps the most important tenet (for me) in the Success Equation book. It provided important clues on how to start attempting to separating Luck from Skill in our Investing activity.

C. Separating Luck and Skill

Mauboussin says, the consequences of our efforts, both good and bad, reflect an element within our control – Skill, and an element outside our control – Luck. In this sense, luck is a residual; it’s what is left over after you’ve subtracted skill from an outcome.

After beating around the bush for whole of 2015, it struck me sometime in 2016 that perhaps this one single para is giving us a decisive clue. If for a stock we own, the business performance over last 1-2 years has been more or less flat or degrown, but Mr Market decided to say double the stock price, there is only once conclusion possible - that there was a whole lot of luck in-built in the Outcome. Consider Poly Medicure during 2016-2017 as one such case.

Conversely, the more we find business performance keeping pace - continually growing, and stock performance keeping pace with this business growth, there might be more skill/better process behind the decision-making?

Over the longer term stock price moves in tandem with business performance, we all accept that. An obvious corollary therefore is that the “Luck” portion is the excess return (residual) that one might have got over and above the business performance - subtracting skill from the outcome? If business performance has been at 25% CAGR over 5 years, and Stock performance has been at 40% CAGR - that excess 15% should be attributed to Luck - with a caveat - for a mature well-discovered business, like say a Bajaj Finance from here on.

However, if it was an emerging business that from a relatively unknown entity, has grown consistently over last 5 years and got well discovered (Institutional entry, PE re-rating), then this becomes tricky. Where should we attribute the excess return to - more of luck, or more of skill?

[Donald]

D. Reversion to the Mean - a Rule rather than an Exception

Mauboussin says, an understanding of where an activity is on the luck-skill continuum also allows you to estimate the likely rate of reversion to the mean. Any activity that combines skill and luck will eventually revert to the mean. This means that you should expect a result that is above or below average to be followed by one that is closer to the average.

By the time I read Mauboussin in 2015, and appreciated that reversion to the mean is a rule rather than exception, we had seen at least 8-10 businesses in VP Public Portfolio deliver extraordinary business performance year after year, sometimes for 3 years or more at a stretch, before pausing (goes without saying most of these were young emerging businesses). So I was prone to dismissing the statistical notion - that a very good year, is most likely followed by a flattish year. But what I did appreciate, almost immediately, is that most of these businesses did take a pause after 3-4 years stretch of a good run; many are unable shake off the shackles, and struggle to do better than average, since the pause.

Mauboussin elaborates, The important point is that the expected rate of reversion to the mean is a function of the relative contributions of skill and luck to a particular event. If what happens is mostly the result of skill, then reversion toward the mean is scant and slow.

When I thought about this in reference to a business/management, I started thinking that while the usual reversion-to-the-mean pattern in our kind of chosen businesses (quality differentiated emerging businesses, dominating a niche of their own) is 3-4 years, there are some business like say PI Industries that seem to be able to defy the reversal to the mean rule and are having an extended stretch for over 7 years; and in our current evaluation likely to continue to defy the rule. I may be proven completely wrong, but this is something I feel very strongly about Bajaj Finance too as a business - that very likely it may continue to defy the rule!!

Mauboussin mentions, Slow reversion is consistent with activities dominated by skill, while rapid reversion comes from luck being the more dominant influence

If a business’s reversion to the mean is scant and slow - as demonstrated in sustained business performance over 6-7 years or more - then it can imply only one thing - that the Management can lay claim to superior business strategy/execution with lot more skill, than luck, isn’t it? They are on top of their job. They know what they are doing.

At the same time if these businesses are to continue to extend their “lucky” stretch, they need the combination of a good dose of luck (Industry remaining stable and growing; as an aside, just look at what happening to Pharma Industry in general, and Ajanta Pharma from the VP universe) and execute strongly on their Skill - Competitive Strategy/Positioning well.

[Donald]

@Donald

However, if it was an emerging business that from a relatively unknown entity, has grown consistently over last 5 years and got well discovered (Institutional entry, PE re-rating), then this becomes tricky. Where should we attribute the excess return to - more of luck, or more of skill?

E. Emerging Business Life Cycle - Being aware of the Chasm

There is always a deep and dividing chasm that separates the early adopters from the early majority. This is by far the most formidable and unforgiving transition in the Technology Adoption Life Cycle

Crossing the Chasm is a very interesting concept from the Venture Capital World that @deepinsight adapted and introduced to us in the 2015 VP Conference for thinking analogously (but more clearly) on public market investing. Always grateful for that important mental model, which stayed with me and I have now adapted for emerging business investing

If I remember correctly the gist of what he said was Venture Capital Investing was all about addressing large opportunity market and that great markets create great businesses. VCs typically likely to invest in a business attacking a large market opportunity at the early adoption stage …before the Chasm. There is higher risk but also that much higher opportunity. He said Public market investing is also about large (but proven) addressable market opportunity. Proven market - implies investing after the Chasm has been crossed. I think he also said Emerging businesses addressing large market opportunity can surprise on the upside on wealth creation.

A business like Bajaj Finance or even a PI industries everyone would acknowledge - has probably successfully crossed the Chasm, given their competitive strategy/positioning are afar ahead of peers, and probably set to ride the market adoption curve for a number of years.

A business like Poly Medicure (with huge potential for Safety Catheters - 2nd company worldwide after Braun) is still struggling at the Chasm - for over 2 years now. Till the time they are able to crack open the large US market - by way of JV/Contracts (or get acquired), they are unlikely to cross the Chasm - Addressable market size remains limited. The same goes for a Mayur Uniquoter - till the time they can sign off on a Mercedes or BMW platform - they are unlikely to crack open a much larger addressable opportunity for them - stuck at the Chasm!!

I find it very useful to think about promising emerging businesses in this way. Investing once they have successfully crossed the Chasm can be very rewarding. But much more rewarding probably is to be aware of the Chasm always - catching them before the Chasm - creating the investing thesis of why they have a great chance of crossing the Chasm!!

The more times we can do that, there is certainly more skill developing - what say?
Recognising that a business is stuck at the Chasm - and likelihood of crossing getting diminished (Management speak/Actions) over time, is an equally important skill, don’t you think?? Art of Selling

Invite Views.

[Donald]

TFor those who might be wondering on the Luck and Skill Conundrum, and whether this discussion is going to lead anywhere , let’s try and move a little closer to ground.

F. Identifying Skill in Business Activity

Mauboussin says, Consider two elements of a manufacturing business. The first is the actual manufacturing process. World-class manufacturers develop very clear processes that are highly repeatable and have very low error rates. Manufacturing is an activity that can fall near the all-skill side of the continuum. A proper process using control systems yields a favourable outcome a very high percentage of the time.

But what about other operational activities like Sales, Marketing, Strategy

He goes on to say, the second element of a manufacturing business is simply deciding which products to manufacture. We call this strategy, and even a well-conceived strategy can fail. Luck could be the more dominant influence here.

We all know business success is not a linear process. It depends on a large number of factors, including competitors, technological developments, regulatory changes, general economic conditions, and the preferences of fickle customers, and more.

Even when a business performs well for a few years, reversion to mean quite often is the norm. Slow reversion is consistent with activities dominated by skill, while rapid reversion comes from luck being the more dominant influence.

Why do we find good businesses declining, so often?

Mauboussin offers some insight. Probably the best explanation for why companies decline is that they fall prey to organizational rigidities. Companies must balance exploiting profitable markets with exploring new markets. Exploiting known markets requires optimizing processes and executing effectively, and leads to reliable, near-term success. Exploring unknown markets requires search and experimentation and offers none of the immediate benefits of exploitation.

This is something we had started pondering upon early on. We are happy with businesses showing demonstrated capability in planning/developing new product-markets every 2-3 years…think an Astral Poly, think an Ajanta Pharma. This is where a Kaveri Seed stumbled - even while everyone knew the primary market Hybrid Cotton seeds is saturated they failed to strategically open up any new markets during the 3-4 years of growth/market domination; while an Avanti Feeds made sure it scaled up the processing segment, when the main feed segment market is close to saturation (though still growing for couple of years surely).

This is also one of the main reasons for holding onto Shilpa Medicare. The Management always thinks 5-10 years ahead. While doing API 10 years back, they were clear about moving into formulations. And just when we were starting to think about what after 2020 - post Oncology success, they spring a super acquisition in bio-similars. There is Japan Market entry already, and a China Market entry in the works, again far ahead of peers, and up the value chain. Sure, near-term performance has been below par, and valuations are far ahead - so no margin of safety for new entry.

This is just to illustrate one more perspective on how to think about businesses - some characteristics pointing to a businesse’s potential to defy the reversion to the mean rule for a number of years. Emphasis - “Potential”. No guarantees. Same way we can think about Bajaj Finance - continually investing in developing revenue streams for the future - far ahead of peers. A rare characteristic! Think PI Industries - from Agrochemicals, to Performance Chemicals, to Pharma Intermediates, to now Electronic Chemicals CSM…every 2-3 years moving up the value chain, ahead of peers.

Re: Companies must balance exploiting profitable markets with exploring new markets. Mauboussin goes on to say, Finding the best balance between exploration and exploitation depends on the rate of change in the environment.

Rate of change in the environment - I find this a significant perspective to drill-in for myself, while thinking about the ODDS of a business to continue to prosper/or face declines. Think IT industry, think Pharma Industry. Think Telecom! Though for Telecom one could start reconsidering, as the ongoing Consolidation settles down with only 3 private players and 2 state run (non-significant) players remaining.

[nirajiitkgp]

Excellent lecture on the same topic by the author of the book at google
https://www.youtube.com/watch?v=1JLfqBsX5Lc

[Donald]

With much of the groundwork laid, let’s start getting to brass-stacks. How should we go about untangling luck and skill in our Investing Journey??

Mauboussin gives enough pointers. He says, when luck plays a part in determining the consequences of your actions, you don’t want to study success to learn what strategy was used, but rather study strategy to see whether it consistently led to success.

Many of my friends are a bit puzzled, and are asking me - why are you spending so much time on this up-and-down exercise, when you know and acknowledge luck and skill are so inextricably mixed up?? Isn’t it futile??

Mauboussin guides - the effort of untangling skill from luck, even with its practical difficulties, still yields great value when we are trying to improve the way we make decisions.

YES, I am convinced there might be great value in this exercise . jhak nahi mar raha
If there is one thing I am always focused on it’s about trying to improve our investing decision-making. Mauboussin is asking us to study what STRATEGIES (decision-making) we have been using - and isolate those that have consistently led to success.

So the next step is to revert now with examples of a) How we used to make our decisions in our early years say 2010-11-12 b) How we make our decisions now in 2016-17. That will be a revealing exercise if I can make a holistic and rigorous attempt at capturing all the decision-making I have done (in active collaboration with gifted colleagues at VP) from 2010, onwards. Am Excited!

Till then, hold your horses , please !

[nityanandparab]

This same question I was asking to myself in last few months how much part Luck plays and how much the hardwork/skills will play. I am still trying to get an answers
I would like to pen my thoughts where actions or results are achieved through Luck or Skills

1. As an investor we try to find new opportunities every now and then and we try to see if the Business we are going to enter is available at the right price-This I can say is based on pure luck as you may find about a company but at a stage where the stock price was already got factored in and the Business is not available at the levels which you would like to enter. One example I can give from Ian Casssels Blog. In one of the posts he had mentioned he found about a company when he was sitting at a station and while reading a newspaper he got to know about this company and then he started researching about it and then invested. The moment that he was present at that station and reading the newspaper can be based purely on Luck. This may happen with many of the people that they get to know about the company they had invested from a friend or they have read an article in a newspaper or they were researching on other topic but accidentally the results thrown by the search engine diverted their attention to this company and they invested in this particular company and many such incidents(if someone agrees on that part that this was coincidence)
2. After finding a good company and researching on it, it totally depends on Investor for how much time he holds it. This can be achieved through the skills that Investor has developed over a period of time
3. Selling at the right time(a really difficult task:smiley: )- This I would like to term partially depends on the Luck. There may be occasions in every Investors life that he regrets the decision of Selling a Stock and after his selling the stock has given more returns than the Investor has anticipated before selling

So the next question which I started asking can we influence in some way this Luck factor and tilt towards us. If you have heard how the people in Sales field achieve their targets on regular basis. Other people say these Salesman were lucky enough to achieve their targets. If we try to dissect how they have achieved that Success then below point comes repeatedly in every Success Story

1. They have tried to influence the Outcome or what they wanted specifically in Life or for that particular period of that life. They use a process called NLP-Neuro Linguistic Programming means saying some statements mainly positive repeatedly so that it helps in achieving the outcome.

As I am in technocommercial job I use NLP techniques on regular basis. Due to my full time job I could not devote my sufficient time to equity research so I sometimes miss a good business which may be available at Good price which I am not aware of. So I started thinking if I can use NLP to succeed in this objective. In last few months I have started working on statements which can be helpful to achieve my this objective. One statement I regularly repeat to myself is “I am getting attracted to good companies”. This may help me find a good company at good valuation which I can keep in my portfolio for a few years and make a sizable income after selling that stock.
Note : I am not able to gauge the outcome of this exercise yet.

For Uninitiated few links are below

NLP

Book which help me understanding the concept few years back “The Power of Your Subconscious Mind”

Note:Views expressed are my personal thoughts and some people may or may not agree on the same.

[Yogesh_s]

@Donald

How should we go about untangling luck and skill in our Investing Journey??

I use a statistical method to ascertain the presence of skill in investment performance. I use a ratio called Information Ratio (aka Appraisal Ratio) for this purpose.

Information ratio is calculated by dividing average of alpha returns (excess return over benchmark) by standard deviation of alpha returns. A high numerator indicates that investor has beaten the benchmark by a wide margin whereas a low numerator indicates that relative performance is poor. A high denominator indicates that this relative performance is inconsistent while a low denominator indicates that relative performance is consistent. Overall a high ratio indicates that relative performance is good and consistent while a low ratio indicates that relative performance is poor and inconsistent.

How does this ratio differentiate between skill and luck? A key assumption here is that an investor can get lucky once in a while and beat the benchmark by a wide margin but one cannot get lucky consistently. Only a skilled investor can beat the benchmark consistently (thus a low standard deviation or low denominator resulting in high ratio). Thus a high value of information ratio shows presence of skill while a low value means performance is largely a result of luck during the analysis period.

[nitinku5021a]

Statistically One can get lucky exactly half of the time.

[Donald]

Hi Yogesh,

Thank you for responding.
I did consider using statistical mechanisms for establishing consistency, but rejected that line of thought quickly - since my purpose in pursuing this is to get better at the game. My perspective was that while statistical measures over a large sample size of investing picks may establish someone’s skill, it does not allow us to learn how to become more skilful

So my natural inclination is to lean towards the perspective that says -

1. “For activities that incorporate a large dose of luck like poker and investing, Skill is best defined as a process of making decisions.”
2. “When luck plays a part in determining the consequences of your actions, you don’t want to study success to learn what strategy was used, but rather study strategy to see whether it consistently led to success.”

This perspective if followed to a logical conclusion, would allow us to study the process/strategy of decision-making. It will also allow us to study the incremental improvements made to process/strategy, whether it led to consistent success (higher success). And that I believe is eminently learnable.

I have some good ideas - to start on decision-making process from my repertoire, but as usual taking time to concisely illustrate. I am on the job!

[nalamada]

Superb stuff !!

On a similar note, find a blog by Morgan Housel linking investment with Quantum physics

The Theory of Maybes

–

N