Thursday, January 10, 2013

Skill and Luck in Investing and Trading

My high school basketball team was a “middle of the district” team—out of eight schools in our league, we were clearly better than three, clearly worse than three and about even with one of the other schools.

Late in my senior year, we played a Christiansburg High team whom we should have beaten, but it was on their court and we didn’t play our best. With seconds to go, it was a tie game. Christiansburg’s best player took a shot that bounced off the rim and traveled fairly far from the basket, out to where the guards (smaller players like me) are usually positioned. I jumped, grabbed the rebound and was slammed by a Christiansburg player who was going after the rebound as well. The ref called the foul and I would shoot a “one and one”, meaning that if I made the first throw, I would get a chance to sink the second.

As I stepped to the line, I still remember an unusual clarity about what was going on around me—an added acuteness of the senses, if you will. Like every basketball player on the planet, I had life-long dreams of one day stepping to the free throw line to take the game winning shot. I had physically practiced this very scenario thousands of times and played it out in my head since I was a little boy tens of thousands of times more.

I went through my normal pre-shot routine and released the ball. As the ball went through the hoop hitting nothing but net, it made the familiar “swish” which was followed by a roar from the fans. With the game won and the pressure off now, the second shot was another swish though to be honest, I remember it less well.

So I had lived out my “little boy” dream of hitting the game winning shot! I believe that a game winning shot and a well-played trade in the markets hold some interesting similarities but some notable differences between the roles of luck and skill.

Luck vs. Skill

An interesting book published in the last few months has gotten some press lately for a couple of reasons. Number one, it is well written and gives some great insights into the nature of success. But more importantly, viewers saw the book in a Warren Buffet office tour he recently granted to CNNMoney. To watch the brief clip, you can watch it here: (Actually, no one mentions the book in the interview but you can barely glimpse the cover under a remote control as the camera pans across Buffett’s desk. Such is the cache of Warren Buffet…!)

The name of the book? The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing by Michael J. Mauboussin. In it, the author writes about the fascinating roles of luck and skill in various activities. I was particularly intrigued by the distinctions that Mauboussin makes about the mix of those two factors in different fields of endeavor.

In certain areas, luck plays a small role while in others, it plays a large role. Where luck has a minor role (like in shooting free throws), cause and effect are closely related. Conversely, there is a looser causal relationship in areas where luck has a bigger part to play (weather forecasting, and yes, trading). In these latter areas (more affected by luck or outside chance occurrences), you can only distinguish skill over time or with a sufficiently large sample size.

Mauboussin also identifies a third category of activity: endeavors that are purely luck. This group would include activities like roulette or the lottery. He describes an easy test to distinguish this last group – skill is required if you can lose on purpose. I can clearly miss a free throw on purpose by shooting the ball 10 feet too short or aiming 90 degrees away from the bucket. But I can’t lose a coin flip on purpose not matter how hard I try (I’ll lose 50% of the time with a fair coin, just like everyone else).

For today, the main point that we can take away is that Van’s decades-long insistence on the importance of psychology in trading is clearly evident in Mauboussin’s work. Why? A horseshoe tossing champ doesn’t have to deal with many forms of uncertainty – his activity is very cause and effect oriented. But because traders and investors deal with uncertainty in every trade, our decision-making biases and processes can either make us or break us as traders! From a trading and investing perspective, I find some of Mauboussin’s insights invaluable. We’ll dig in more next week and I look forward to sharing more of Mauboussin’s work with you in future articles.

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