Renowned author and investment strategist Michael Mauboussin gave this great talk at Google earlier this year. It is absolutely one of the most fascinating speeches I’ve ever heard. In this article, I’d like to share with the readers a few key takeaways I jotted down while listening to the talk, including a fantastic Q&A session.
https://www.youtube.com/watch?v=1JLfqBsX5Lc
1. The concept of “paradox of skill” is really fascinating and totally counterintuitive. It basically says that in activities where skill and luck define outcomes, as skill improves, luck becomes more important in determining outcomes. This idea comes from Stephen Jay Gould, a very eminent biologist at Harvard. Mr. Mauboussin cited the example of marathons. Many decades ago, the difference between the first place and second place of a marathon race was more than half an hour. Today it is less than a minute. Because everyone’s gotten better, as a result, the standard deviation of skill has actually narrowed. This fascinating point is this paradox of skill. We see it in the world of investing as well. I think it is very interesting. As skill improves, especially in competitive markets, luck becomes more important in determining outcomes.
2. The definition of luck. This is equally fascinating. We all heard the sayings such as “luck is where success meets preparation” or “you make your own luck.” Mr. Mauboussin says that this is only partially true. He redefines luck as the occurrence when three conditions are in place. Number one is that it happens to an individual or organization, so it could be you or the organization you work for. Secondly, it can be good or bad. Third, it’s reasonable to expect a different outcome could have occurred. When those three things are in place, luck exists. Another simpler way to think about it is if you cannot control the outcome, say if you can’t lose a game on purpose, then luck plays an important role. For instance, you can’t lose roulette on purpose, but you can easily lose a chess game on purpose.
3. Why do we struggle with understanding luck? Mr. Mauboussin pointed out that once an event occurs, something happens in all of us rapidly and effortless, which is our mind creates a narrative to explain the outcome and then we file that narrative in our mind. As we do that, two things happen – hindsight bias and creeping determinism, which is when you start to believe that what happened was the only thing that could have happened. If the paradox of skill is true – absolute skill is never higher and relative skill is never narrower, means luck is determining more outcomes. That’s colliding with a mind that really struggles to understand the role of luck.
4. How do we get better?
- Deliberate practice
- Focus on more process – analytical edge, behavioral biases and organizational
- You really have to be circumspect about trying to predict the outcome of path dependent processes
Q and A Notes:
Question 1: Are the skills in the investing profession not improving?
Answer: Investing would be a little bit more on the luck side. The investing profession on the whole is very skillful. But the problem is they are all doing the same thing so their skill is extremely uniform. This is a classic example of the paradox of skill. If you have the technology available now and you are a money manager in the 1960s or 1970s, you will run circles around everybody. So the absolute skills have improved, but the relative difference got narrower.
Q2: You said cognitive ability peaks out in the 40s or 50s, and since Warren Buffett (Trades, Portfolio) is now more than 80 years old, is he not as good as he was younger? Also, it’s hard to find who’s actually a great value investor, but if you had to find one, what would be a good way to do it?
Answer to part 1: Buffett is extraordinary at every age stage. He’s doing less traditional money management these days so the game has changed a little bit. But he might struggle competing with a 40-year-old version of himself.
Answer to part 2: Seth Klarman (Trades, Portfolio) said that “value investing is at its core the marriage of contrarian streak and a calculator." He meant that you have to have the ability to go against what everybody else is doing. But sometimes the consensus is right, and you can’t be a contrarian just for the sake of it. The calculator is the second part, which means the gap between price and value. To answer your question, from a characteristic point of view, great value investors tend to not care what other people think about them. From an organizational point of view, an organization that is conducive to quality decision making is also important.
Q3 : People with similar skill levels will get the same views. So if we look from the outside and maybe we call this a collective view. Is the collective view determining the result instead of luck?
Answer: Let’s use a simple language such as the “Wisdom of the Crowds.” When are crowds are wise and when are crowds mad? Crowds tend to be wise when three conditions are in place: diversity of the underlying agents, a properly functioning aggregation mechanism, and the right incentives. When those three things are in place, you often get very efficient economic results. When one of these three conditions is violated, you get inefficiencies. For instance, when we all believe the same thing, then we lose the diversity of opinions condition.
Q4: Most of us in the room try to be outliers or the best. My take from your talk is that I should try to be in the group of people who are best, but that group is getting bigger and bigger and the standard deviation is getting smaller. After that I kind of have to hope for luck. How do you deal with this powerless feeling of 'I did my best but it’s still not in my control'?
Answer: In some ways it’s liberating as opposed to powerless. If you look at the most successful people in the world, they were all incredibly lucky at some point. You should do everything in your effort to succeed, but there’s no one that is a massive outlier that is not lucky.
Q5: How do you go about hiring people who have succeeded in life through skills but also through luck on some level that you can’t tell?
Answer: A guy at HBS named Boris Groysberg wrote a book called “Chasing Stars.” And what he actually studied was this idea of hiring stars from other organizations to join your organization, and this turned out to be a very poor practice. Most people’s skills don’t translate from one organization to another effectively, this is less true in athletics but certainly true in the world of business. Another great book “the Halo Effect” basically illustrates that we spin stories to fit the narrative that are not very well placed.
