Michael J. Mauboussin is always worth reading. Those who are unfamiliar with his pieces for Legg Mason may remember him for his highly acclaimed book More Than You Know: Finding Financial Wisdom in Unconventional Places. He’s back with his third book, which has its roots in a 42-page essay from 2010. The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing (Harvard Business Review Press) is yet another good read.
The premise is straightforward: if we are to make sound decisions, we have to understand the relative roles that skill and luck play. Sometimes these roles are obvious. If I buy a lottery ticket, anything that comes my way is the result of pure luck. If I take on Tom Brady in a football passing contest, I am guaranteed to lose in a most humiliating way because of the gargantuan gap in skill. But most of the time both skill and luck contribute to a given outcome. If we don’t recognize this, and if we don’t understand the properties of skill and luck, we can fall for outsized claims (“the best trading system ever, 200 wins in a row”) or delude ourselves into thinking that simply by practicing more deliberately we can join the pantheon of legendary traders and fund managers.
It’s bad enough that, given the complex nature of markets, trying to succeed in trading or investing requires more than a modicum of luck. Another problem is what Mauboussin calls the paradox of skill: “As skill improves, performance becomes more consistent, and therefore luck becomes more important.” (p. 53) In investing the paradox manifests itself in the following way: As the population of skilled investors increases, with individual retail investors retreating to the sidelines, the variation in skill narrows, and luck becomes more important. (p. 89)
What’s a poor bloke to do? Mauboussin maintains that “in activities where luck plays a strong role, the focus must be on process. Where skill dominates, performance is a dependable barometer of progress. But where luck is a stronger force, the link between process and outcome is broken. A good process can lead to a bad outcome some percentage of the time, and a bad process can lead to a good outcome. Since a good process offers the highest probability of a good outcome over time, the emphasis has to be on process.” (p. 222)
Mauboussin covers a lot of ground in The Success Equation. For instance, he explains what reversion to the mean is and isn’t (it does not imply that results will cluster closer to the average). And he writes about the arc of skill, obvious in aging athletes but also a problem for the aging investor; the peak age for investing skill is 42.
I’m sure that almost everyone will find something in this book that either he hadn’t thought about before, or that he thought about incorrectly.