Skill vs. Probability.

Lucky, or good? This question gets asked a lot, but few realize how important it is.

Having just finished Michael Mauboussin's book, Think Twice, I couldn't help but reconsider this question across a range of areas.

It turns out to be crucial in sports, business, politics, investing, and even parenting!

The basic issue is that the outcomes we see are one part skill, and one part probability, (i.e. luck). Where we get wrapped around the axle is when we assume that bad luck means bad skill, or, more frequently, that good luck means good skill.

Sports seems like the most obvious example. People assume hot and cold streaks are due to controllable skill, when they're much more likely due to good and bad luck. A 60% free throw basketball shooter has a 7.8% chance of making 5 in a row; a 40% shooter has a 1% chance of 5 in a row. But, that doesn't mean that on any given night the 40% shooter won't shoot better than the 60% shooter. Sorry, that's just probability.

A better example is the Sports Illustrated jinx. Teams or athletes tend to do worse after they appear on the cover of Sports Illustrated. Luck or skill? They were probably on the cover because they had skill and a streak of good luck. The did worse afterward because they had skill and a streak of bad luck. Fans will probably claim otherwise, but it's more likely a change in luck than skill.

The same phenomenon occurs in business. Companies and managers that appear on the front of Business Week, Forbes and Fortune tend to under-perform afterward (both their stock and underlying performance metrics). Were they on the cover because they were terribly skillful, or because they had skill and were a bit luckier than average? This doesn't bode well for Apple, Google or Hewlett Packard that have graced a lot of magazine covers recently.

You can see the same thing in a business's underlying performance. If a company is shooting the lights on in sales and profits, it's part luck and part skill. A company with terrible performance may be terrible, but it's also likely to be partly bad luck. The statistics show that performance tends to regress to the mean over time--the good get worse and the bad get better.

Politics and entertainment are also good examples. Was Bush purely to blame for 9/11 and hurricane Katrina, or was he unlucky? Likely, he was both unlucky and unskillful, but he's frequently blamed as if it were all bad skill. Same for Obama. Was he unlucky or unskillful to have the housing market meltdown and a giant oil spill in the Gulf of Mexico on his watch? People aren't very objective in judging politicians and the degree to which luck plays a part, especially when they go into situations with political prejudices.

I've found luck and skill even play a part in parenting. If you're saying "DUH!?" right now, I agree with you. When my almost 3 year old daughter is sick or teething (which I consider luck, not skill on my part), things go worse. This means tantrums galore! When she isn't sick or teething, things go a lot better. She occasionally even listens to me! My skill is the same (or at least relatively stable), but my results are different because luck plays a part.

No where is this more obvious in my life than with investing. Luck plays a major part in investing because the outcomes are due to so many complex factors. Predicting economic outcomes, weather patterns, competitive dynamics, etc. makes investing a terribly difficult area to separate skill from luck. And yet, both good and bad luck are there along with skill.

That's why its so important to look at a managers long term record. If he or she does well over the long run but hasn't done well recently, bad luck is probably playing a part and good luck will eventually come back. On the flip side, a good record doesn't necessarily mean skill and good luck, it could just be good luck. This burns investors more than anything else in the investing world, and it counts when looking at investing managers as much as specific investments (Apple, anyone?).

Skill or statistics? Lucky or good. You be the judge. But, don't fool yourself that both good and bad luck aren't playing a roll. They most certainly are.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.