Morningstar Advisor - April/May 2013 - (Page 16)

10 Questions Luck, Skill, and Investing Michael Mauboussin Managing Director, Global Investment Strategies at Credit Suisse; author of The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing. Mauboussin will be speaking at the Morningstar Investment Conference, June 12–14, Chicago. Interviewed on March 8. 1 What got you interested in looking at the roles that luck and skill play in outcomes? Luck and skill have been relevant in almost everything I have done. I have been involved in sports as an athlete, a coach, and a fan. In business, I’ve always been intrigued by luck. And, of course, investing is a business with lots of luck. 2 How can you tell if a person is more good than lucky? The easiest way is to start with the activity itself. Some activities are almost all skill. A faster runner will beat a slower runner every time. But some activities have a lot of luck. So, it’s possible to build a stock portfolio that will beat Warren Buffett in the short run, but in the long haul, his skill will shine through. So, when you see success in skill-dominant activities, you can say someone has been more good than lucky. 5 You do an interesting thing in the book by putting luck and skill at opposite ends of a spectrum. Where does investing land? Investing in the short run is closer to the luck end. But two issues are worth noting very quickly. Investing is not dominated by luck because investors are not skillful; it’s quite the opposite. Investors in the aggregate are very skillful. But that skill means that stock prices reflect the information and expectations that are out there. Second, that luck is important doesn’t mean that the whole process is random. Investing is about deferring current consumption in order to consume more in the future. So, it’s a positive expectation activity. Now, in the short run, we don’t know what will happen. But over longer time periods, asset-class returns tend to be more stable. tends to improve, relative skill tends to become more uniform. In plain words, that means that the difference between the best and the average is less than what it used to be. So, the best hitter in baseball is closer to an average player today than was the case 50 years ago. So, if luck plays the same role throughout time, it is more influential today than in the past. 8 With this awareness, how can we become better investors? To me, the answer lies in thinking carefully about what you are trying to achieve and aligning your strategy to serve your goal. This means saving an appropriate amount and investing for the long run in appropriate asset classes given your age, wealth, liabilities, and risk tolerance. Most of us don’t have a good plan that we stick to. 6 What does this mean for investors? First, investors shouldn’t lose sight of the idea that investing is a positive expectation game. Second, they should be mindful of their emotions—there’s a pernicious 9 How does reversion to the mean trip up investors? of your control is often luck. 4 What’s the luckiest thing that has happened to you? In the professional realm, the moment when a colleague of mine handed me a copy of Alfred Rappaport’s book, Creating Shareholder Value , in 1987. It shaped my thinking on a lot of topics and led me to a wonderful mentor. 16 Morningstar Advisor April/May 2013 he or she can assess skill, they should use active managers. If they have no time to think about managers, then indexing makes sense. 7 What is the paradox of skill? 3 What is your definition of luck? I suggest that luck exists when three conditions are met: It happens to an individual or group; it can be good or bad; and it’d be reasonable to expect a different outcome could have occurred. Another, even simpler, way to think about it would be what is in your control versus what is out of your control. What’s out Reversion to the mean says that outcomes that are far from average will be followed by outcomes with an expected value closer to the average. The classic mistake is to get too excited about the market after it has done well and put money in at the top, and to get too despondent when the market is down and pull money out. Being mindful of reversion to the mean may at least temper this tendency. 10 What’s the next topic you’re tackling? pattern of investors selling out at the bottom and buying toward the top. Finally, if an investor believes that The paradox of skill says that when the outcome of an activity combines skill and luck, as skill improves, luck becomes more important in shaping results. So more skill leads to more luck. The key to the paradox of skill is distinguishing between absolute and relative skill. While absolute skill I am very interested in how to forecast effectively; how our minds sort and catalog outcomes; portfolio construction; and isolating skill in business management— among other topics. That’s the wondrous thing about the investment world—there’s always a lot to explore!

Table of Contents for the Digital Edition of Morningstar Advisor - April/May 2013

Morningstar Advisor - April/May 2013
Contents
Contributors
Letter From the Editor
The Pursuit of Happiness and Financial Advice
What Strategies Do You Use to Control Risk?
Driven to Succeed for Clients and Family
How to Assess a Portfolio’s Bond Risk
Luck, Skill, and Investing
Investments á la Carte
Investment Briefs
Investing’s No- Brainers Have Costs
A Defensive Ride
Risk On/On Risk
The Risk of Being Overconfident
Year of Living Dangerously
The Risk-Parity Approach
A Guide to Mutual Funds Running Risk-Parity Strategies
What Moats Tell Us About Risk
Risk’s Wake-Up Call
Seeing Is Believing
Why Investors Lag the Returns of Their Funds
Liquidity Signals
Pump Them Up
Golden Oldies Keep on Truckin’
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
Our Social Blind Spot

Morningstar Advisor - April/May 2013