Page 3 Legg Mason Capital Management
Exhibit 1: The Skill-Luck Continuum
Source: LMCM analysis.
One point is worth making right upfront: the outcomes of any activity that combine skill and luckwill exhibit reversion to the mean. More technically, an extreme outcome (good or bad) will befollowed by an outcome that has an expected value closer to the mean. Reversion to the mean isa tricky concept, and the relative contributions of skill and luck shed light on its significance for various activities.There’s a simple and elegant test of whether there is skill in an activity: ask whether you can loseon purpose.
If you can’t lose on purpose, or if it’s really hard, luck likely dominates that activity.If it’s easy to lose on purpose, skill is more important.In this report, we will discuss why unraveling skill and luck is so important, provide a frameworkfor thinking about the contribution of skill and luck, offer some methods to help sort skill and luckin various domains, and define the key features of skill in the investment business.
Why It’s Important to Understand Skill
My son’s terrific rowing coach, Yuri, a former member of the Ukrainian National Rowing Team,refuses to let anyone bid the athletes “good luck” before a race. He insists that they say, “Goodeffort.” Yuri understands that crew races are about skill, not luck, and doesn’t want the rowers or the spectators to think otherwise.Yuri is ahead of the game. Appreciating the blend of skill and luck in an outcome is helpful in anumber of ways:
Creates a template for assessing outcomes
. The information content in a small number of outcomes varies greatly based on where the activity lies on the continuum. When skilldetermines an outcome, a relatively small sample size is revealing. For example, chessplayers earn a rating based on their game results. That rating is a solid proxy for skill(even though the skills of players are constantly improving or deteriorating). A player whois rated 200 points higher than his or her opponent is expected to win 75 percent of thetime.
By contrast, you need a large sample size when luck plays a large role in an outcome.The reason is that you have to see enough outcomes to ensure that luck has evened outand that only skill is revealed. In some high-luck domains, it takes a long time to gather asufficient sample to sort skill and luck. The best teams tend to rise to the surface over a162-game major-league baseball season, for instance, but a short series is mostly luck.