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“I think it may be true that fortune is the ruler of half our actions, but she allows the other half or a little less to be subject to us.” – Niccolo Machiavelli in the Prince
On June 3, 2017, Alex Honnold scaled El Capitan free solo without a rope: he climbed 3000 feet of vertical granite wall, with his hands and some chalk in what is probably the most impressive in sports history. 3 hours and 56 minutes of just focus, strength, and most importantly, skill.
Buy Tencent a year ago for $ 354, watch it rise 34% in 3 months $ 474, then crash 40% to $282 – this can be attributed to good luck followed by bad luck.
The influence of luck on outcomes has been understood for a long time. Despite the presence of every manipulative trick in the quiver of his political director Niccolo Machiavelli the role that Luck played a role in successful outcomes in the guide to the rulers of the future.
Five centuries later, Michael Mauboussin wrote about the difficulty of distinguishing luck from skill in business sports and investing in the success equation. It shows how the different activities sit on the scale of luck and skill: chess sitting on the far right of the diagram (pure skill), the slots machines sit on the far right of the diagram (pure luck). Where the investment is located in this scale?
Nobel laureate Eugene Fama and Ken French published a paper “luck versus skill“, where they analyzed the performance of more than 3,000 US mutual funds from 1984 to 2006 through the lens of their Fama-French 3 factor model (i.e. modify the performance of the excess risk that the money taken).
They discovered that in a full active fund universe underperformed the market by about the fees that are charged to investors.
Of course some of the funds to miss some of the funds without the level. How much of its investment because of skill and not luck? Professors Fama French decided that only 3% of mutual funds outperformed the always net of fees. But the number that did outperform the market with a high degree of certainty it is less than what is expected by random chance. (Source: IFA)
Mauboussin believes that why Luck is very important in investing is not that investors are not skilled – IT’s actually the opposite.
Imagine if AlphaGo Google DeepMind champion beating the computer program played against itself. The winner of each match will be more dependent on luck, as skill. This is an extreme example, but the same applies to investment.
Investors are more intelligent and skillful, get more information today. Collectively they have become more efficient in incorporating information into stock prices. As a result, the result become more consistent with less dispersion of good and bad results. Mauboussin calls this the development of skill.
As skill improves, where the average skill level improves, it in fact increases the dependence on luck in determining the results. Perhaps aware of the importance of luck in investing (and life) is a skill in itself. (Source: CNBC)
The more dependent the result on luck, and most importantly is to focus on the process. If you rely only on luck, you may get good (or poor) the result with some random probability.
A good process will give you the highest probability of achieving successful results in the long term. If markets have taught us anything – it is to be humble and admit that we’re not all “above average” and we don’t know what the future holds. Instead of gambling our hard earned savings and rely on luck, we prefer to invest and remain committed to evidence-based disciplined.
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